Counting the Costs

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Counting the Costs

• Errors and omissions in making economic decisions
• Frank/Bernanke, Chapter 1 (part 2)

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Error 1 Forgetting opportunity costs
The economic cost of an action includes the
cost of opportunities not taken -- the cost of
college includes not only tuition, but also wages
not collected because of the job not taken. --
the cost to GM of manufacturing more SUVs
includes not only the price of steel and plastic
and glass, but the profit not made on sedans
which were not produced.
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Example the Wallflowers and the Wilburys (Frank,
ch.1, prob. 10 -- modified)
Wallflowers are giving a free concert the
Wilburys are giving a concert which will cost 8
on the same night. You prefer the Wilburys your
reservation price for hearing their concert (if
you had no other option) is 12. What is the cost
of hearing the Wallflowers? Their concert is
free, but going to it means giving up the
opportunity to hear the Wilburys and gain 4 of
economic surplus (12 reservation price - 8
cost) Go to the Wallflowers only if you value
their concert at more than 4, the value of the
opportunity foregone.
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Kwame Nkrumah the Decision Maker
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Soap ?
Selling Ghanas soap http//www.island.net/ydrum
s/black.htm
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or cocoa?
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Example interest on loans

• Interest on loans is often regarded as unfair
• Aristotle found it unnatural
• In the Middle Ages, it was labeled usury and
  regarded as sinful.
• Most countries still maintain usury laws
  limiting the amount of interest that can be
  charged.
• http//www.time.com/time/europe/biz/magazine/0,986
  8,99926,00.html
• Note that there is an economic justification for
  some limits on the rate of interest see from the
  University of Bari http//www.dse.uniba.it/Semina
  ri/CocoDemeza.htm

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Interest and opportunity cost

• The opportunity cost argument for interest is
  simple if you loan money to anyone, you give up
  the opportunity to invest it productively.
• wherever a great deal can be made by the use of
  money, a great deal will commonly be given for
  the use of it Adam Smith, Wealth of Nations,
  (Book I, ch. 9, p. 90 of Cannan edition)
• Hence, in our North American and West Indian
  colonies, not only the wages of labour, but the
  interest of money, and consequently the profits
  of stock, are higher than in England (p. 94)

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Mike the Mushroom Farmer

• Mike knows that if he invests his spare cash in
  mushrooms, he can make a profit of 20 percent at
  the end of one year, and expects the price to
  remain constant.
• If Zoe asks Mike for a loan of 10,000, she
  should not be surprised to be asked to pay 20
  percent interest Mike is giving up the
  opportunity to make that much profit.
• In practice, adjustments will be made for the
  risk that the loan is not repaid (risk
  premium), and for the risk that mushroom price
  will fall.

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Error 2 considering sunk costs

• Sunk costs or fixed costs are costs which
  will be incurred whether or not an action is
  taken.
• They should be ignored in deciding on a course of
  action.
• If youve bought the (non-refundable) ticket to
  the football game, should you attend during a
  blizzard? Your answer should be the same as if
  you were given the ticket for free.

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Fixed and Variable Costs

• If you own a car, you have to pay
• Fixed costs such as loan payments and insurance
• Variable costs such as gasoline, new tires (the
  old ones wear out only if the car is driven)
• The decision about whether to take a trip should
  be based on the variable costs alone, since these
  are the only costs that will change if you take
  the trip.

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Average and marginal costs

• The fixed/variable distinction is closely related
  to the average/marginal distinction.
• Total costs Fixed costs plus variable costs.
• Average cost Total cost divided by number of
  units of a good (or level of activity).
• Marginal cost Change in variable cost resulting
  from one more unit of a good (or an increase in
  the level of an activity).
• Note that the definition could have said Change
  in total cost, since variable costs are the
  only ones that change.

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The Pajama Game

• The musical did have an economic theme a
  dispute over a wage increase of seven and a half
  cents.
• Here, we assume you are the manager, worried
  about
• How to pay the interest on the money you borrowed
  to build the pajama factory.
• How to keep track of the costs of producing
  pajamas.

http//www.sonymusic.com/clips/selection/30/089253
/089253_01_02_30.wav Click above for the title
song.
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TC 10000 5 Q

• The above cost equation is a way of tying
  together the different cost concepts.
• Total cost Fixed cost variable cost
• The 10,000 is fixed you will pay 10,000
  whether or not you produce a single pair of
  pajamas (interest on loans to build plant)
• The 5 Q term varies with quantity you will pay
  another 5 for each pair of pajamas you produce
  (for cloth, buttons, labor)

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Average cost

• Average cost Total cost divided by Quantity
• If Q 1000, TC 10,000 5 (1,000) or
  TC 15,000
• If Q 1,000 then AC 15,000 divided by 1000,
  or Average Cost 15.00.
• Repeat for Q 2000, to find
• TC (at 2000) 10,000 5 (2,000) 20,000
• AC (at 2000) 20,000 divided by 2,000 or
  average cost 10.00
• Note that average cost decreases with output

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Variable and Marginal Cost

• Total Cost 10,000 5 Q
• Fixed cost 10,000 (doesnt change with Q)
• Variable cost 5 Q (increases when Q increases)
• Marginal cost 5
• Every EXTRA unit of production means an EXTRA
  cost of 5.
• Note that in this case marginal cost does not
  increase with quantity.

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Graph of total cost
Costs ()
Total Cost 10,000 5 Q
Fixed cost 10,000
10,000
1000
2000
Pajamas
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Graph of total cost
Costs ()
Total Cost 10,000 5 Q
20,000
15,000
Fixed cost 10,000
10,000
2000
1000
Pajamas
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Graph of total cost
Costs ()
Total Cost 10,000 5 Q
20,000
15,000
Fixed cost 10,000
10,000
2000
1000
Pajamas