ECC1000 Chap.2 Costs, Economic Profit and Decisions at the Margin
Costs, Economic Profit and Decisions at the Margin
Two kinds of decision, two pieces of machinery
Week 2 splits decisions in two. An either-or decision picks one option from a set, such as starting a business or staying employed, and is settled by comparing economic profit across the alternatives. A how-much decision picks a quantity, such as how many hours to work or how many units to produce, and is settled at the margin.
The first thing a good answer does is say which kind of decision the question poses, because applying the wrong machinery produces a fluent answer to a different question.
Explicit, implicit, and the sum that matters
An explicit cost requires an outlay of money: rent, wages, materials. An implicit cost is the dollar value of a benefit given up by making the choice, and it appears on no invoice.
Opportunity cost is the two added together. That is why accounting profit, which subtracts only explicit costs, can be comfortably positive while economic profit, which subtracts the forgone alternative as well, is negative.
A positive economic profit means the option beats its best rival; a negative one means the rival wins even while the bank balance rises.
The trap that catches most answers
Resources the decision-maker already owns still cost something. The implicit cost of capital is the income those assets would earn in their next best use, and it applies to premises, equipment, savings and the owner's own labour alike.
Two versions of the same venture, one renting everything and one owning it, produce identical economic profits and very different accounting profits.
That gap is not a curiosity; it is the standard shape of an examinable question, because it is exactly where intuition and the model disagree.
Marginal cost, marginal benefit and the stopping rule
A how-much decision weighs what the next unit adds to cost against what it adds to benefit.
Most activities show marginal cost rising or at least constant while marginal benefit falls, and that pairing produces a single crossing point. Take the largest quantity at which marginal benefit still covers marginal cost. Below it, each unit adds more than it costs; above it, each unit destroys value.
Two cautions carry the marks: the marginal cost here is a marginal opportunity cost, so it includes implicit items, and with whole units the optimum is the last integer unit that still pays rather than the exact crossing point of two lines.
Sunk costs, and where the model stops
A sunk cost has already been incurred and cannot be recovered, so it is identical under every option still open and must be excluded.
The sentence that gives the error away is the claim that so much has been invested that stopping is impossible; the correct comparison uses only the remaining cost and the remaining benefit.
The chapter closes on behavioural economics, which studies how real decisions depart from this model in systematic rather than random ways, through concern for fairness, over-confidence, and the bounded capacity to work through every option. Treat those as amendments to the benchmark, not as a reason to abandon it, because the benchmark is what lets you measure the size and direction of the departure.
What this chapter covers
- 01
Either-or against how-much decisions
- 02
Explicit cost, implicit cost and their sum
- 03
Accounting profit against economic profit
- 04
The implicit cost of capital you already own
- 05
Eliminating three or more options pairwise
- 06
Marginal cost and marginal benefit curves
- 07
The stopping rule and the whole-unit optimum
- 08
Sunk costs, and the behavioural departures the unit names
Same venture, two ownership stories, one answer
- 1Total the explicit costs in each version.
- 2Total the implicit costs, including every owned resource used.
- 1State both profits and the decision they support.
Key terms
- Explicit cost
- A cost requiring an actual outlay of money, such as rent, wages or materials.
- Implicit cost
- The dollar value of a benefit forgone by taking an option, appearing on no invoice.
- Accounting profit
- Revenue less explicit costs only, which is the figure a financial statement reports.
- Economic profit
- Revenue less explicit costs and less implicit costs, so measured against the best alternative.
- Marginal cost
- What the next unit adds to total cost.
- Marginal benefit
- What the next unit adds to total benefit.
- Sunk cost
- A cost already incurred and unrecoverable, so irrelevant to any forward-looking choice.
- Bounded rationality
- The limited capacity of a decision-maker to evaluate every option before choosing.
Costs, Economic Profit and Decisions at the Margin FAQ
Why can a business be profitable and still be the wrong choice?
Because the figure being quoted is accounting profit, which subtracts only the money that left the account. Once the salary and the earnings of any owned assets are subtracted as well, the same venture can show a loss against the best alternative. That second figure is what the decision turns on, and the gap between the two is the size of the forgone alternative.
How do you handle a decision with three or more options?
Compare a pair, discard whichever shows negative economic profit against the other, then compare the survivor with the next option and continue. Exactly one option survives, because economic profit is always measured against the best rival: an option that beats the best of the rest cannot be beaten by any of them.
Should past spending ever appear in the calculation?
No, provided none of it can be recovered. Amounts already committed are the same under every remaining option, so they cancel out of the comparison exactly as a shared cost does. Compare only what remains to be spent against what remains to be gained, even when the project as a whole will end in a loss.
Does behavioural economics mean the marginal rule is wrong?
It means real decisions depart from the rule in patterned ways, not that the rule is useless. The benchmark is what allows a departure to be described at all: without computing what the model predicts, there is no way to say how far behaviour moved or in which direction, and an answer that skips the benchmark has nothing to compare against.
What exactly is meant by the implicit cost of capital?
It is the income an owner's own assets would earn in their next best use. A workshop occupying premises it owns forgoes the rent those premises could command, and that forgone rent belongs in opportunity cost even though no payment is ever made. The same treatment applies to the owner's own time and to money tied up in the venture.
Exam move
Drill this chapter by rewriting scenarios rather than solving them. Take any worked case and change one detail, such as making a hired input owned or removing a recoverable cost, then predict which of the two profit figures moves before recomputing. Keep a running list of the amounts you were tempted to leave out; that list is the marking scheme in miniature.
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