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2) Rational Decision Making.pdf

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James Pesando

ECO100: LECTURE #2 14/09/11 OPPORTUNITY COST REVIEW: You decide to go out for dinner which costs $100. You value the dinner at $200. Your next best alternative is to attend a concert, which you value at $75. The cost of a ticket to the concert is $50. 1. What is the opportunity cost of going out to dinner? a) $25 b) $50 c) $75 d) $125 e) none of the above 2. What is the opportunity cost if you value the dinner at $400? a) $25 b) $50 c) $75 d) $125 e) none of the above Answer: Action taken: $100 (direct cost) Next best alternative: 75 Less: Direct cost of next best alternativ(50) $125 (for both questions) Observation: the value that you assign to the dinner is irrelevant to its opportunity cost. RATIONAL DECISION MAKING Undertake activity if marginal (additional) benefit exceeds marginal (additional) cost Insights 1. Include all opportunity costs 2. Ignore sunk costs: (“fixed costs”) costs which are incurred whether or not action is taken i. Only relevant costs are those which can be avoided if action is not taken. Example: Restaurant: Should it Stay open for Lunch? Lease payment: $12000 per month  $400 per day Dinner: 150 meals Lunch: 25 meals Additional (Marginal) Revenue 25 meals @ $20 = $500 Additional (Marginal) Costs Chef: 3 hrs @ $30 = $90 Waiters (2) : 6 hrs @ $10 = $60 Food: 25 meals @ $5 = $125 Total: $275 ***NOTICE LEASE IS NOT INCLUDED Conclusion: 1) $500-$275 = $225  profitable to stay open 2) Fixed (sunk) cost of lease is not relevant Example 2: You buy $30 concert ticket, but lose ticket on way to the concert. Should you buy a new ticket (if you have the funds)? Marginal Cost = $30 Marginal Benefit > $30 (or you would not have bought original ticket) Example 3: You buy a ticket in advance and pay a reduced price of $50. Unfortunately
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