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ECO100 - SEP 12

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James Pesando

Rational (economic) Decision Making Two key building blocks: 1) opportunity cost 2) Marginal Analysis 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) Definition: Costs which are incurred whether or not action is taken. Insight: Only relevant costs are those which can be avoided if action is not taken. #1. 1. Marginal benefit of attending sports event: $100 (both Jack and Jill) 2. Ticket Price: $50 1) Jack buys one week in advance 2) Jill plans to buy on day of event 3. Subway breaks down on day of event, and Jack and Jill both face unexpected cost: $75 for taxis. 4. Should Jack attend the event? Should Jill attend the event? Answer Jack SHOULD attend: MB = 100 MC=75 MB> MC [TICKET PRICE IS A SUNK COST FOR JACK, NOT FOR JILL] - price (fixed cost) does not enter into the decision. Jill SHOULD NOT attend: MB = 100 MC= 75+50=125 MB MC, so repair the truck. loss is less if repair the truck Profit: 6,000 - 8,000 = - 2,000 If not repair the truck profit = 0 - 3,000 = -3,000 #3. 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 = 500 Additional (Marginal) Costs chef: 3 hours at 30 = 90 Waiters (2) = 6 hours at 10 = 60 Food: 25 meals at 5 = 125 $275 Conclusion: 1) 500 - 275 = 225 -> profitable to stay open 2) fixed (sunk) cost of lease is NOT relevant #4 You buy a concert ticket in advance and pay a reduced price of 50. Unfortunately, when you arrive at the concert, you discover that you lost the ticket. As planned you took a taxi to the concert and the taxi cost 20. The cost of the concert ticket at the door is 65. If you have the funds, should you buy a new ticket? ANSWER: Buy new ticket. Marginal Benefit has to the at least 70 Marginal cost: 65 Note: Marginal benefit is at least 70 (since you were willing to pay at least 50 for the original ticket plus 20 for the taxi) INCENTIVE Alters marginal benefit or marginal cost of an action (an
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