Chapter 3

Question 1

Define Opportunity Cost

Answer 1

the opportunity cost of an action is what you give up (forgone profit) to pursue it.

• Costs imply decision-making rules and vice-versa
• The goal is to make decisions that increase profit
• If the profit of an action is greater than the alternative, pursue it.

Question 2

What do you consider WRT Costs and Benefits

Answer 2

In computing costs and benefits, consider

• all costs and benefits that vary with the consequences of a decision
• and only those costs and benefits that vary with the consequences of the decision.

These are the relevant costs and benefits of a decision.

Question 3

Define Fixed and Variable Costs

Answer 3

Fixed costs do not vary with the amount of output.

Variable costs change as output changes.

Decisions that change output will change only variable costs.

Question 4

What is the “fixed cost” or “sunk cost” fallacy

Answer 4

The fixed-cost fallacy or sunk-cost fallacy means that you consider irrelevant costs. A common fixed-cost fallacy is to let overhead or depreciation costs influence short-run decisions.

Question 5

What is the hidden cost fallacy

Answer 5

The hidden-cost fallacy occurs when you ignore relevant costs. A common hidden-cost fallacy is to ignore the opportunity cost of capital when making investment or shutdown decisions.

Question 6

Identifying Costs

Answer 6

“What decision am I trying to make?”

• If you start with costs, you will always get confused
• If you start with a decision, you will never get confused

Question 7

Define EVA

Answer 7

Economic Value Added

• EVA®= net operating profit after taxes minus the cost of capital times the amount of capital utilized
• Makes visible the hidden cost of capital
• The major benefit of EVA is identifying costs.

If you cannot measure something, you cannot control it.

Question 8

Define the Endowment Effect

Answer 8

the endowment effect means that taking ownership of item causes owner to increase value she places on the item.

Question 9

Define Loss Aversion

Question 10

Define Confirmation Bias

Answer 10

confirmation bias – a tendency to gather information that confirms your prior beliefs, and to ignore information that contradicts them.

Question 11

Define Anchoring Bias

Answer 11

anchoring bias – relates the effects of how information is presented or “framed”

Question 12

Define Overconfidence Bias

Answer 12

overconfidence bias – the tendency to place too much confidence in the accuracy of your analysis