ECON1123-CH9-NOTES-DECISION MAKING BY INDIVIDUALS AND FIRMS – Flashcards

Angus works as a dairy farmer and loves his work. Because the dairy business hasn't been doing well lately, Angus is considering changing careers. He could work as a technician at the local diary plant, and earn $27,000 a year. Angus decides to make a list of the costs of staying in business as a farmer and asks you for help. Please sort Angus' costs below according to whether they are explicit costs or implicit costs. EXPLICIT COSTS: the wage he PAYS to his hired hand the feed he BUYS for his cows the gas he USES for his farm truck the COST OF VETERINARY CARE for his cows IMPLICIT COSTS: the TIME it takes him to milk all of his cows The 27000 annual salary he would receive from working at the dairy plant. --- Explicit costs are those that require the outlay of the MONEY. Implicit costs are measured by the value of the benefit foregone. The wages, feed, gas, an veterinary care are all items that Angus must continue to purchase if he wants to stay in business as a dairy farmer. All of these items require him to SPEND MONEY. The implicit costs DO NOT require him to spend money. The cost of these items is what he is giving up by not pursuing them. The time he spends milking cows is the time he could have been used on another activity. Lastly, by remaining a dairy farmer, Angus would be giving up the salary that he could have earned working at the dairy plant. While he DID NOT actually spend this money, he would be GIVING UP THE OPPORTUNITY TO EARN IT, and so it therefore stills counts as a cost.

what is the primary difference between accounting profit and economic profit? -Accounting profits IGNORE implicit costs (CASH); economic profits consider them (CASH AND NON-CASH). Russ owns a fried chicken stand that operates at the local beach. In calculating how much he earns from his business, Russ notices a difference between his economic and accounting profits. Why would Russ' economic profit differ from his accounting profit? -He may have implicit costs associated with operating the chicken stand in addition to explicit costs. --- The primary difference between accounting profit and economic profit concerns implicit costs. Accounting profit is taken after subtracting explicit costs from revenue and then adjusting the amount for depreciation. Thus, it deals only with funds that have actually been given and received. Economic profit, however, considers all opportunity costs, both explicit payments and implicit costs. As a result, the economic profit of an enterprise is almost always smaller than its accounting profit. Both accounting profit and economic profit occur when money is made, and if no money is made then this is a loss rather than a profit. Additionally, both types of profit consider capital in all its forms, not just financial assets. Lastly, it is accounting profit that requires the exchange of money. The most likely reason for a difference in Russ' accounting and economic profits is that he had implicit costs in addition to his explicit costs. While both types of profit would have factored in his explicit costs, the implicit costs would have only been considered in calculating economic profit. There is no information present about whether or not Russ earns a profit and this would not any explain any discrepancy because the type of profit is not defined. There is also no information regarding consumer demand, though this might have an impact on his profits if it was proven to be true. Lastly, accounting profit, as well as economic profit, considers the tax cost of operating the business, so this would not cause a discrepancy.

reggie owns and operates a cheese shop in the village of somerset. While Reggie has a degree in mechanical engineering and could easily go to work for his brother's company earning 76000 a year, his true passion is or cheese. Below is a list of Reggie's expenses from 2010, please use information provided to answer the questions that follow. What is Reggie's accounting profit? REVENUE - EXPENSES AND DEPRECIATION 90000-18000-6000-3000=63000 What is Reggie's economic profit? REVENUE - EXPENSES AND DEPRECIATION - IMPLICIT COSTS 90000-18000-60000-3000-76000 = -13000 ACCOUNTING PROFIT = REVENUE - EXPLICIT COST ECONOMIC PROFIT = ACCOUNTING PROFIT - IMPLICIT COST or REVENUE - EXPLICIT COSTS - IMPLICIT COSTS

Please match each of the following scenarios with the term below that best fits the description provided -Jackson manages his father's fruit stand. He takes an accounting of all the company's assets, including equipment, tools, financial assets and inventory. These items are examples of: CAPITAL -Abe owns a candy shop and at year end calculates his revenue minus his explicit cost. the result is an example of: ACCOUNTING PROFIT -Hailey decides to buy a pretzel from the cart outside her office. She pays 3.25 in cash for her lunch. The 3.25 is an example of : EXPLICIT COST ~ SUNK COST -Annabelle runs a tutoring company. In determining her costs and benefits from the venture, she includes her opportunity costs from choosing to open the tutoring business. She is evaluating the firm's ECONOMIC PROFIT -Sacha leaves his job as a nuclear engineer to become a train conductor. One day, while riding the rails, he considers the salary he could have earned had he remained an engineer. This is an example of: IMPLICIT COST Ginny works for an investment firm an after reviewing the investment decisions her firm made last year, considers other ways the funding could have used. She is considering her: IMPLICIT COST OF CAPITAL. --- The capital of a business is the combined value of all of its assets. These include its equipment, any buildings or facilities it may own, tools used for its business, inventory of its products and any financial assets it may have in its possessions. Jackson manages all of these assets for his father's company, and so manages the company's capital. Abe calculates the accounting profit for his candy shop. He takes the total revenue earned and subtracts his explicit costs, the ones for which he had to pay out money, and arrives at his accounting profit. An explicit cost is one for which money must be paid out. When Hailey pays for her pretzel, she is incurring an explicit cost. When Annabelle considers the opportunity costs for her business, she is calculating the economic profit. This takes into account the cost of what had to be given up in order to make the decision. In this case, she considers what was given up to open her tutoring company. Sacha is considering his implicit cost, the opportunity cost of making the decision to become a train conductor. He considers the dollar value of his salary had he remained as a nuclear engineer, and counts these lost potential benefits as a cost in his choice to become a train conductor. The implicit cost of capital is the opportunity cost of the capital. Ginny considers other ways that the capital her firm invested could have been used. When considering the total economic profit earned by these investments, Ginny will consider the benefits that could have been experienced from a different decision and consider these as an economic cost.

Match the definitions below with the terms at the right that most closely align with the description. The cost of producing one more unit of a good or service: MARGINAL COST The situation where an additional unit of a good or service costs the same as each of the former units: CONSTANT MARGINAL COST The benefit experienced from undertaking one more unit of an activity: MARGINAL BENEFIT. a situation where the expense of producing one more unit of a good or service is greater than that of producing the previous unit: INCREASING MARGINAL COST the amount that, when produced or consumed, results in the greatest possible net gain. OPTIMAL QUANTITY The situation that occurs when the gain from an additional unit of a good or service is less than that gained from producing the previous unit. DECREASING MARGINAL BENEFIT. --- The marginal cost of a good or service is the cost of producing one more unit. It differs from total cost in that total cost is the sum of producing all units of a good or service, whereas the marginal cost is the cost of producing the most recent unit. This cost can be the same, greater than, or less than the cost of producing other units. Constant marginal cost is a situation in which the marginal cost remains the same for each unit produced. The situation often occurs when there are fixed per unit costs, such as buying raw supplies for a restaurant or in adding additional workers to your company who all earn the same wage. Marginal benefit is the benefit gained from producing one more unit of a good or service. Just like with costs, the term "marginal" refers to the benefit of the most recent unit while the term "total" indicates a focus on the accumulated benefits from all units consumed or produced. Increasing marginal cost occurs when the cost of an additional unit of a good or service is greater than the cost of the previous unit. This can occur when there is a change in the productivity of inputs. As firms produce more, they will experience increasing marginal costs if additional units of labor or capital aren't as productive as earlier units. The optimal quantity is the level of production at which the greatest possible benefit is obtained. If a firm produces any less than this, there is still benefit to be gained and it should rationally choose to produce more. If a firm produces any more than this, it can increase the benefit gained by reducing output. Decreasing marginal benefit occurs when an extra unit of a good or service produces less benefit than the unit that was produced before it. ***For example, if the first hour spent studying economics improves your exam score by a greater amount than the second hour of studying does, then you would have experienced a decreasing marginal benefit.

Albert owns a breakfast diner and decides to add a new item to his menu, the Peerless Omelet. Albert must decide how many eggs to include in each omelet so that he makes the highest profit. Please use the information in the chart below to answer the questions that follow. How many eggs should Albert include in the omelet?6 What kind of marginal cost does Albert have? constant --- Though not depicted on the chart, this is simply a case of marginal analysis. The marginal cost for each additional egg is $0.45, meaning that it costs this much for Albert to add one more egg. As he adds eggs, he also increased the price he charges for the omelet. The change in price from one size to another gives him his marginal benefit. Any rational producer would stop producing at the point where marginal cost exceeds marginal benefit, and for Albert, this point would be 6 eggs. If he produces omelets with 3, 4, or 5 eggs he would be missing out on profit he could earn by including more. Also, if he produced omelets with 7 or 8 eggs, he would face the situation of being able to increase his profit by reducing the number of eggs included and dropping his price. Six eggs in each omelet is his profit-maximizing point. Albert faces a constant marginal cost. The cost to add each egg is the same as the cost of the egg before it. Due to various market conditions he is unable to charge this same price increase for each omelet, and so demonstrates the principle of decreasing marginal cost and optimal quantity.

Patrick has chosen to double-major in finance and microbiology and studies 14 hours a day as a result. To make it through his studies. Patrick relies on GreenCow energy drinks. Below is a chart of his marginal costs (MC) and marginal benefits (MB) from consuming GreenCow. What is the optimal quantity of GreenCow drinks for patrick? 5 can obviously What occurs if Patrick consumes more than the optimal quantity? The extra benefits Patrick gets from another can are no longer worth the cost. --- The optimal quantity for Patrick to consume is 5 cans of GreenCow. This is the quantity where MARGINAL BENEFIT EQUALS MAGINAL COST. For all quantities up to the 5th, the marginal benefit is higher than the marginal cost. This means that Patrick's net benefit is increasing, and consuming all units up to this point make him better off. If Patrick were to consume any more than 5 cans of GreenCow, the cost of each additional can would be higher than the additional benefit (because the marginal cost curve is higher than the marginal benefit curve). Consuming any cans beyond the 5th therefore makes him worse off. It cannot be determined if the other answer choices are true based on the information provided here.

On your way home from Super Groceries your car breaks down. It is a hot summer day and you have nobody to call. With little time before the food soils, you decide to prioritize what to carry on the walk home. You choose to take three items with you. Since you will need all five items toady, you will replace the two abandoned items at the corner store near your house, Convenient Grocers. The table below contains prices you paid for each good at Super Groceries and the price you will need to pay at Convenient Grocers to replace the goods. Which three items should you save? Place them in the bin. Leave the rest of the items unplaced. BEEF, EGGS, FRUITS --- The important concept to remember here is that of sunk costs. In this case, the price that you paid for the items at the Super Groceries is a cost that you cannot recover. The only price that matters is the price it will cost you to replace the items. So you should ignore Super Groceries' prices and save the three items with the highest price at Convenient Grocers, which are beef, eggs, and fruits. This means you only need to replace milk and vegetables at a cost of $2.75 and $2.95. Note that if you had saved beef, milk, and vegetables, which had cost you the most, you would have to replace eggs and fruits at a cost of $4.75 and $3.60.

Acme Drug Inc is developing a new cancer suppressant drug, Limisol. Following clinical trials and the granting of a patent, the Food and Drug Administration has given the company permission to sell the drug. Below is a table showing the actual and projected costs and revenue for the firm, assuming an interest rate of 0%. All values are in hundreds of thousands. Acme is currently entering Year 4 of the development. Please specify all numerical answers to two decimal places. What is the total value of this project's sunk costs (in hundreds of thousands) 40+30+5+1.75+7.5 = 89.25 What are the total future costs 35+20+35+20+35+20=165 consider all relevant information, would you recommend the company to continue to manufacture this drug? YES REVENUE = 60+60+60 =180 --- Going forward, the sunk costs in years 1-3 are irrelevant. The only relevant information are the projected costs and revenues in years 4-6. The costs are calculated above. The revenues are, in hundreds of thousands: 60+60+60=180 As projected future revenues are higher than projected future costs, you should recommend that Acme Drug Inc continue to manufacture Linisol, as this activity will be profitable. ***REALIZE SUNK COST IN LIFE. Even though the profits are not high enough to recoup the R and other costs already paid, these costs cannot be recovered and should not factor into the decision moving forward.

In each scenario below, please label which mistake they made in regard to economic decision making. -Alexander is heavily invested in the stock of Nortel, a telecommunications giant. However, Nortel has been in steady decline and despite the fact all signs point to the fact Nortel will likely go bankrupt, Alexander holds onto his stocks, unwilling to sell unless he makes back at least the money he invested into it. - LOSS AVERSION. SUNK COST IN RL -Jim is washing his laundry and as he checks his jean pockets, he finds an unexpected windfall of $50. Elated because it was $50 more than he had before, he decides to splurge on a lobster and filet mignon dinner. -MENTAL ACCOUNTING - Geneva is a researcher at Genentech, a biotech firm and faces decision paralysis every time a big question is posed to her. When her boss asks her what project she wants to work on, she says she is indifferent every time, so her boss just assigns her to a project. STATUS QUO BIAS -Tiffany lives in Alameda, CA. She recently got two job offers, one in Oakland and one in San Francisco.The San Francisco job pays $1000 more per year, so Tiffany accepts the job. However, she quickly realizes the travel time, which is an hour more each way, quickly becomes a burden. - MISPERCEIVING OPPORTUNITY COST - Steve is trying to diet. Each day he says the diet will begin today, but each time he eats a potato chip, he indulges in it. The next day, he promises his diet will really start, but the vicious cycle continues. OVERCONFIDENCE --- There are six common economic decision making mistakes: Loss aversion is the inability to acknowledge a loss has occured and to move on. RL! This is one of the predominant reasons why sunk costs are hard to ignore as it means that money you spent is unrecoverable. Alexander has a loss on his stocks, but instead of selling them to keep what money he has, he is unwilling to accept the loss. Counting dollars unequally tends to result in mental accounting, where values on certain money is more or less than others. Regardless where or what form the money is, $50 is still $50!!. Finding extra money does not make it more valuable than any other money in your bank account. Overconfidence also has a bearing on rational decision making, often resulting in rash decisions due to people thinking they know more than they actually do. Unrealistic expectations about future behavior also has a bearing on rational decision making. It is at its core, another form of overconfidence. Steve keeps saying he will eventually diet, but that day never seems to come. Misperceptions of opportunity costs occus when people have a tendency to ignore opportunity costs that do not involve money. Tiffany looked only at the salary as she made a job decision, but did not factor in the travel time and distance. Status quo bias is the tendency to avoid making a decision at all, or to colloquially put it, go with the flow. Geneva doesn't give any input on what project she works on, so her boss just decides to start assigning her to whatever needs work.

Economic models are typically based on the principle that people behave rationally. However people do not always behave rationally. Which of the following is NOT a reason why economists still consider their models valid in spite of the irrationality of people? -people typically behave more rationally over time. really?!!! irrational behavior is kind of unusual. -because the existing models have been in place fro so long, they are considered untouchable, the equivalent of an economic law*** - ANSWER -for the sake of simplicity, it is easier to create models from generalizations rather than seemingly random irrational behavior -despite the flaws in the model, the models are still thorough predictors of market behavior. --- Economists, for a variety of reasons, choose to consider their models valid despite the irrationality of people. It is simpler to create broad generalizations of rational people than from sporadic irrational behavior. People also tend to behave more rationally as time goes on when they learn from prior mistakes. Although irrationality does introduce potential flaws into models, the models themselves still provide plenty of robust, useful information to economists. Just because an economic theory or model has been in place for a long time does not mean it cannot be disputed or proven wrong.