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Lecture 2

ECO101H1 Lecture Notes - Lecture 2: Sunk Costs, Marginal Cost, Marginal Utility


Department
Economics
Course Code
ECO101H1
Professor
James Pesando
Lecture
2

Page:
of 5
ECO 100Y – Sept 16th 2015
Announcements: Hart House investor’s club sept 21st 6pm
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Notes:
The Economic Way of Thinking
Rational (Economic) Decision Making
- O.C
- Marginal Analysis
[Review] O.C. of an action is what you forgo by not taking the best alternative action. -> YOU HAVE TO
IDENTIFY WHAT IS THE NEXT BEST ALTERNATIVE!!If the OC of taking an action is high, you are less likely
to take the action.
Measuring O.C.
= Action Taken + Next Best Alternative(Dollar amount or value assigned by you) Direct Costs
Insight:
1) The benefit of the action taken does not influence its opportunity cost. (Aka value taken does not get
taken into from action taken)
2) O.C is a measure of COST: what you forgot by taking the action, as measure by best alternative action.
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Rational Decision Making – Undertake activity if marginal (additional) benefit exceeds marginal
(additional) cost
Insights:
1) Include all opportunity costs
2) Ignore sunk costs
Sunk costs – Fixed Costs; Costs which are incurred whether or not action is taken
Insight – Only relevant costs are those which can avoided if the action is not taken
Example:
Marginal benefit of attending a concert: $100 (both Jack and Jill)
Ticket price: $75
Jack buys one week in advance, Jill plans to buy on day of concert
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The subway breaks down, and Jack face an unexpected cost: $50 for a taxi
Question:
Should Jack attend the concert?
Should Jill attend the concert?
Answer:
Jack should attend:
MB = 100 MC = 50 MB>MC (Ticket is sunk cost as he already bought the ticket, the marginal cost is
only the cost of taxi and since the MB is greater than MC. Ticket does not influence his decision as cost is
already incurred)
Jill should not attend:
MB = 100 MC = 75+50 = 125 MB<MC (For jill, who has not purchased her ticket, the ticket is NOT a
sunk cost as she did not buy the ticket yet.)
Example 2:
You buy a broken guitar for $300, which will sell for $700 if fixed. You expect the repair will require 5
hours of your time. Your next best alternative is to work overtime at your job and earn $50/hour.
After you spend 5 hours, you have created more damage, and the resale value of the guitar is 0. It will
take you 10 additional hours to repair it. Should you do so?
Answer:
(Note the O.C. of your time is $50 per hour)
MB of repairing guitar: $700 [$700 – 0]
MC of repairing guitar: $500 [10h x $50/h]
MB > MC
Observation: The 5 hours you have already worked is a “sunk” cost and is not relevant to your decision.
Follow-up question:
Would you repair the guitar if your next best alternative is to earn $75/ hour?
Answer: no. MB = 700 MC = 750 MB<MC
Example 3:
You buy, in advance, a ticket for a hockey game at the discounted price of $75. As planned, you take a
taxi to the game, which costs $40. You lost the ticket when you arrived.
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Question: If you have the funds, should you buy a new ticket, which costs $100
What is marginal cost?
MC is $100 (Note: the $75 paid for the first ticket is a sunk cost and does not influence MC, same with
the taxi fee)
What is marginal benefit?
MB equals at least $115 (Note: the MB is at $115 since you were willing to pay $75 for the original ticket
and $40 for the taxi) Infer from the question if it is not stated
MB>MC, therefore you will buy the ticket. (Note: Although the $75 you paid for the original ticket is a
sunk cost, this price-together with the taxi fare provides information as to the MB to you of attending
the hockey game)
Answer: If you are rational, you buy the ticket since MB>MC
Restaurant: Should it stay open for lunch?
Lease payment: $12 000 per month -> $400 per day
Dinner: 150 meals
Lunch: 25 meals
Additional (Marginal) Revenue
25 meals at $20 (Assume) = $500
Additional (Marginal) Costs
Chef: 3 hours at $30 = $90
Waiters (2): 6 hours at $10 = $60
Food: 25 meals at $5 = $125
Total: $275
Conclusion:
1) $500-$275 = $225 -> Profitable to stay open
2) Fixed cost of lease is not relevant as it is a sunk cost
3) If you only sell 8 meals, you lose money, therefore it would not be profitable to stay open
Incentive – Alters marginal benefit or marginal cost of an action (and can thus affect whether an action
is taken)
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