Module 17 krugman 1
Module 17
Making Decisions
What’s New in the Fourth Edition?
• Updated Teaching Tips
• Updated Business Cases
• Handouts for use in class
Module Objectives
• Why does good decision making depend on accurately defining costs and benefits?
• What is the difference between explicit and implicit costs?
• What is the difference between accounting profit and economic profit and why is economic profit
the correct basis for decisions?
• What are the three types of economic decisions?
Teaching Tips
Costs, Benefits, and Profits
Creating Student Interest
• Use Handout 17-1 to have students brainstorm the costs of going to college or Handout 9-7 to
consider the implicit and explicit costs of raising children.
Presenting the Material
• Use Handout 17-2 or 17-4 to have students consider the costs, both implicit and explicit, of
operating a business.
Making “How Much” Decisions: The Role of Marginal Analysis
Creating Student Interest
• Ask students to estimate how long they plan to spend studying for their next economics exam. You
can have them write their estimates on a small slip of paper and collect them. Look at the estimates
and determine a rough estimate of the average. Have them consider whether this is the optimal
number of hours (minutes?) to study. Why wouldn’t they want to study longer? Why not stop
studying earlier? Ask for suggestions of what they would need to consider to determine the
optimal number of hours to study. They need to know their goal for the class, the benefits of
Presenting the Material
Module 17 krugman 2
• Use Handout 17-3 for students to think about the marginal decision involved in the optimal choice
of output for a business.
Sunk Costs
Creating Student Interest
• Have students consider the following scenario. Two friends have purchased memberships to a
fitness center. They have agreed to work out together every Monday, Thursday, and Saturday.
Leslie paid $600 for her annual membership; Amy, who waited for a special membership
promotion, paid $100. In both cases, the fee was paid in full, in advance, and is nonrefundable.
After the first few months of their agreement, Leslie and Amy’s school starts having a special
concert every Saturday so Amy decides she is only going to work out twice a week. Leslie tells
Amy that because she paid $600 for her membership, she is going to continue going to the gym
every Saturday, even though it means missing the concert. Ask the students if they think the
friends made the best decision and why.
Presenting the Material
• Give the class the following additional information about Leslie and Amy (from the preceding
scenario). Leslie and Amy both love to attend concerts. They are music majors and get great
enjoyment from listening to all kinds of music. Both of the friends stay very fit carrying around
their instruments and neither much enjoys working out. Leslie especially hates working out if her
best friend Amy isn’t with her.
Now have the students think about the following questions:
1. If Leslie continues going to the gym every Saturday, how much does the gym
2. If Leslie stops going to the gym every Saturday, how much does the gym membership
3. What does Leslie gain from going to the gym alone on Saturday? (Nothing—she is
5. Since the $600 is a sunk cost (Leslie cannot get it back no matter what she does), she
6. Make sure students see the difference between sunk costs and explicit costs. Explicit
Common Student Pitfalls
Module 17 krugman 3
• Total cost versus marginal cost. Students may be inclined to think that if marginal cost is
decreasing, then so is total cost. Remind them that marginal cost is extra cost so that as long as
marginal cost is positive, total cost will increase.
• Muddled at the margin. Students may confuse the idea of setting marginal benefit equal to
Module Outline
I. Costs, Benefits, and Profits
A. Explicit versus implicit costs
1. The true cost of anything (its opportunity cost) is what you must give up to get it.
Opportunity cost can be divided into explicit cost and implicit cost.
2. In considering the cost of an activity, you should include the cost of using any of your
own resources for that activity.
B. Accounting profit versus economic profit
1. Companies report their accounting profit, which is not necessarily equal to their
economic profit.
2. Businesses can face implicit costs for two reasons. First, a business’s capital could
have been put to use in some other way. Second, the owner devotes time and energy to
the business that could have been used elsewhere.
3. Forgone interest earnings from financial assets used to pay for college are used to
illustrate implicit cost of capital.
C. Making “either-or” decisions
1. An either-or decision requires you to choose between two projects.
II. Making “How Much” Decisions: The Role of Marginal Analysis
A. Marginal analysis involves comparing the benefit of doing a little bit more of some activity
B. Marginal cost
1. For the production of some goods, the shape of the marginal cost curve changes as
more output is produced. Marginal cost may first decrease, then become constant, then
increase.
2. The simple case is to assume increasing marginal cost.
C. Marginal benefit
1. In some cases marginal benefit is constant, such as when the perfectly competitive
firm takes market price as given. Each unit sold yields the same price, or marginal
benefit.
2. The example in this Module assumes decreasing marginal benefit.
D. Marginal analysis
1. The profit of an activity is the difference between the marginal benefit and the
marginal cost. Profit can be calculated for each unit of a good produced.
2. The optimal quantity is the quantity that generates the highest possible profit.
Module 17 krugman 4
3. Total profit is the sum of the profit earned in each individual year for the schooling
example, or for all of the units of the good produced.
4. Text Figure 17-3 illustrates the optimal quantity as the quantity whose marginal
benefit is equal to marginal cost.
Figure 17-3
5. According to the profit-maximizing principle of marginal analysis, when faced with a
profit-maximizing “how much” decision, the optimal quantity is the largest quantity at
which the marginal benefit is greater than or equal to marginal cost.
E. A principle with many uses
1. The principle of marginal analysis can be applied to a variety of “how much”
decisions, including those whose benefits and costs are not measured in dollars.
2. Some examples:
a. A consumer has to decide how to allocate a weekly budget between restaurant
meals and mocha lattes.
b. A producer has to decide on the size of a new store.
c. A physician has to decide on the optimal dosage of a drug by considering the
marginal cost in terms of side effects versus the marginal benefit in terms of
fighting the disease.
III. Sunk Costs
A. A sunk cost should be ignored in decisions about future actions.
B. The choice between replacing parts on a car or selling the car and buying another car is used
in the text to illustrate sunk costs.
Case Studies in the Text
Economics in Action
Module 17 krugman 5
The Cost of a Life—This EIA considers the “marginal cost of a life” and the role it can or does play in
policy decisions.
Ask students the following questions:
2. Can we make an efficient decision about using our resources for a particular policy (like
Module 17 krugman 6
Handout 17-1
Date_________ Name____________________________ Class________ Professor________________
College Opportunity Costs?
Consider the costs of attending college. Write the costs in the appropriate column and estimate the
amount of each cost. Sum the implicit costs. Sum the explicit costs. Then, calculate the opportunity
cost of attending college.
Implicit cost
Estimate
Explicit cost
Estimate
Total implicit costs
Total explicit costs
Module 17 krugman 7
Handout 17-2
Date_________ Name____________________________ Class________ Professor________________
Explicit and Implicit Costs
Consider the following scenario and answer the questions that follow.
Larry has decided to quit his job working at Quickie-lube and become an entrepreneur. He had been
earning $2,500 per month performing oil changes. Since he has his own garage, which he had been
renting out for $400 per month, he has decided to open his own oil-changing business. His monthly
costs and revenue are shown in the following list. Note: we are assuming no depreciation.
Price of oil change = $25
Oil changes per month = 200
Cost of oil = $5 per oil change
Equipment rental = $200 per month
Other expenses = $1,000 per month
1. What is Larry’s total revenue for the month?
2. What are Larry’s explicit costs for the month?
3. If an accountant figured Larry’s profit, what would it equal?
4. What costs does Larry have that are not considered by the accountant?
5. If an economist calculated Larry’s profit, what would it equal?
6. What does the negative economic profit signal to Larry?
Module 17 krugman 8
Answers
Larry has decided to quit his job working at Quickie-lube and become an entrepreneur. He had been
earning $2,500 per month performing oil changes. Since he has his own garage, which he had been
renting out for $400 per month, he has decided to open his own oil-changing business. His monthly
costs and revenue are shown in the following list. Note: we are assuming no depreciation.
Price of oil change = $25
Oil changes per month = 200
Cost of oil = $5 per oil change
Equipment rental = $200 per month
Other expenses = $1,000 per month
Have the class work through the answers to each of the following questions:
6. What does the negative economic profit signal to Larry? (His accounting profit is $2,800. If
Module 17 krugman 9
Handout 17-3
Date_________ Name____________________________ Class________ Professor________________
Carpet Cleaning
Sam begins to clean carpets for family and friends. He is trying to determine the optimal quantity of
carpets to clean. In the table below, calculate Sam’s marginal costs and marginal benefits. Also,
calculate his total gain at each quantity of carpets cleaned.
Quantity of
carpets
cleaned
Total
cost
Marginal
cost
Total
benefit
(price)
Marginal
benefit
Total
net gain
0
$ 0
$—
$ 0
$—
$—
1
20
60
2
42
110
3
68
150
4
100
180
5
140
200
What is Sam’s optimal number of carpets cleaned? Is this the point of maximum total net gain?
What is happening to marginal benefits as the number of carpets cleaned increases? Why is this
happening?
What is happening to marginal costs as the number of carpets cleaned increases? Why is this
happening?
Module 17 krugman 10
Answers:
Sam begins to clean carpets for family and friends. He is trying to determine the optimal quantity of
carpets to clean. In the table below, calculate Sam’s marginal costs and marginal benefits. Also,
calculate his total gain at each quantity of carpets cleaned.
Quantity of
carpets
cleaned
Total
cost
Marginal
cost
Total
benefit
(price)
Marginal
benefit
Total
net gain
0
$ 0
$—
$ 0
$—
$—
What is Sam’s optimal number of carpets cleaned? Is this the point of maximum total net gain?
What is happening to marginal benefits as the number of carpets cleaned increases? Why is this
happening?
What is happening to marginal costs as the number of carpets cleaned increases? Why is this
happening?
Module 17 krugman 11
Handout 17-4
Date_________ Name____________________________ Class________ Professor________________
Ski Rental Costs
Calculate the accounting profit and economic profit for the following case study.
The owner of Crested Butte Ski Rentals purchased $150,000 worth of skis for rentals. The revenue from
the rentals is $300,000. Utilities are $20,000 per year and wages are $50,000. There is an outstanding
loan, and the interest owing per year is $12,000. If the skis had not been purchased, the owner could
earn $11,500 in annual interest income on the $150,000 otherwise used to buy the skis. The owner
was offered a managerial position at another ski shop for $40,000 a year.
Accounting profit
Accounting profit
Economic profit
Accounting profit
Revenues:
Revenues:
Costs:
Costs:
Total cost:
Total cost:
Total accounting
profit:
Total economic
profit:
Should the owner continue in business? Why?
Module 17 krugman 12
Answers
Accounting profit
Accounting profit
Economic profit
Accounting profit
Costs:
Costs:
Total cost:
Total cost:
profit:
profit:
Should the owner continue in business? Why?
Revenues:
Revenues:
Module 17 krugman 13
Handout 17-5
Date_________ Name____________________________ Class________ Professor________________
Expensive Babies
In her book The Price of Motherhood, Ann Crittenden claims the total cost for a college-educated
couple to have a child is $1 million over the child’s lifetime. She discusses the following items as the
costs of an educated woman having a child. Classify these as explicit or implicit costs of having a child.
1. Unearned social security credits
2. Forgone promotions
3. Salary while not working
4. Expenses for baby’s room
5. Loss of experience at work
6. Depreciation of work skills
7. Food and clothing for the child
8. Loss of pension benefits
9. Awards given for excellence in your paid job
10. Babysitting fees
11. Preschool expenses
12. Earnings from paid work contributed by an employer to a retirement account
13. Doctor visits/medical expenses
14. Costs of decorating child’s room
15. Lost training opportunities at work
Module 17 krugman 14
Answers