Chapter 9: Decision-Making

Question 1

What determines quality of decisions?

Answer 1

Our understanding and computation of costs and benefits. The opportunity cost of any activity is equal to its explicit cost plus its implicit cost (this includes the resources of the decision-maker: money, time, capital).

Question 2

Common mistakes with either-or decisions?

Answer 2

People or businesses use their own assets in projects rather than rent or borrow assets as this overestimate economic profit by underestimating implicit costs. Time is also an implicit cost often forgotten.

Question 3

Factors of profit-maximizing principle of marginal analysis:

Answer 3

Total cost = sum of marginal costs
Additional profit = marginal benefit - marginal cost.
Optimal quantity is when MC = MB. When this is the case, total profit is maximised as difference between total cost and total benefit is maximised.
Total profit = sum of additional profit

Question 4

4 characteristics of rational humans, but lower monetary payoff:

Answer 4

Concerns about fairness
Non-monetary rewards – the principle of diminishing marginal utility suggests that non-monetary rewards are preferred to monetary payoffs since they produce direct satisfaction rather than satisfaction through consumption.
Bounded rationality – making a choice close to the highest payoff since computing the best payoff is too costly.
Risk aversion – the uncomfortability of a risk pushes people away from the best choice.

Question 5

7 mistakes leading to irrational behavior:

Answer 5

Misperceptions about opportunity cost – forgetting implicit costs, sunk cost fallacy.
Overconfidence – relying on past success, not doing proper cost-benefit analysis.
Unrealistic expectations about future behavior (form of overconfidence)
Counting dollars unequally – mental accounting
Loss aversion
Framing bias – some form of bounded rationality. Anchoring
Status quo bias – decision paralysis, loss aversion. This has led to nudges.

Question 6

Why do models exist for irrational humans?

Answer 6

Still provide robust predictions
Market forces compel people to act more rationally in the long run
Assuming rationality makes modelling simpler. Even behavioral economists search for predictably irrational behavior.

Question 7

Why does behavioral economics exist?

Answer 7

Models assume monetary rationality but humans can either have rationality unrelated to monetary payoffs as the primary goal, or humans can be irrational.

Question 8

How are consumption and production how-much decisions different?

Answer 8

Consumers are limited by income.

Question 9

KEY TERM:
Explicit costs

Answer 9

a cost that requires an outlay of money.

Question 10

KEY TERM:
Implicit costs

Answer 10

a cost that does not require the outlay of money; it is measured by the value, in dollar terms, of benefits that are forgone.

Question 11

KEY TERM:
Accounting profit

Answer 11

revenue – explicit cost.

Question 12

KEY TERM:
Economic profit

Answer 12

revenue – opportunity cost.

Question 13

KEY TERM:
Capital

Answer 13

the total value of assets owned by an individual or firm — physical assets plus financial assets.

Question 14

KEY TERM:
Implicit costs of capital

Answer 14

the opportunity cost of the use of one’s own capital — the income earned if the capital had been employed in its next best alternative use.

Question 15

KEY TERM:
Principle of either-or decisions

Answer 15

the principle that, when faced with an “either-or” choice between two activities, choose the one with the positive economic profit.

Question 16

KEY TERM:
Marginal cost

Answer 16

the additional cost incurred by producing one more unit of that good or service.

Question 17

KEY TERM:
Increasing/decreasing marginal cost

Answer 17

each additional unit costs more/less to produce than the previous one.

Question 18

KEY TERM:
Marginal cost/benefit curve

Answer 18

a graphical representation showing how the cost/benefit of producing one more unit depends on the quantity that has already been produced.

Question 19

KEY TERM:
Marginal benefit

Answer 19

the additional benefit derived from producing one more unit of a good or service.

Question 20

KEY TERM:
Increasing/decreasing marginal benefit

Answer 20

each additional unit of an activity yields more/less benefit than the previous unit.

Question 21

KEY TERM:
Optimal quantity

Answer 21

the quantity that generates the highest possible total profit.

Question 22

KEY TERM:
Profit-maximizing principle of marginal analysis

Answer 22

the proposition that in a profit-maximizing “how much” decision the optimal quantity is the largest quantity at which marginal benefit is greater than or equal to marginal cost.

Question 23

KEY TERM:
Sunk costs

Answer 23

a cost that has already been incurred and is not recoverable. A sunk cost should be ignored in decisions about future actions.

Question 24

KEY TERM:
Behavioral economics

Answer 24

a branch of economics that combines economic modeling with insights from human psychology to understand how people actually make decisions.

Question 25

KEY TERM:
Rational

Answer 25

describes a decision maker who chooses the available option that leads to the outcome they most prefer.

Question 26

KEY TERM:
Non-monetary reward

Answer 26

benefits or payoffs that are not financial in nature; examples include increased leisure time and “feel-good” experiences.

Question 27

KEY TERM:
Risk Aversion

Answer 27

describes individuals who choose to reduce risk when that reduction leaves the expected value of their income or wealth unchanged.

Question 28

KEY TERM:
Bounded rationality

Answer 28

a basis for decision making that leads to a choice that is close to but not exactly the one that leads to the best possible economic outcome; the “good enough” method of decision making.

Question 29

KEY TERM:
Irrational

Answer 29

describes a decision maker who chooses an option that leaves them worse off than choosing another available option.

Question 30

KEY TERM:
Sunk cost fallacy

Answer 30

the mistaken belief that a sunk cost represents an opportunity cost.

Question 31

KEY TERM:
Mental accounting

Answer 31

the habit of mentally assigning dollars to different accounts so that some dollars are worth more than others.

Question 32

KEY TERM:
Loss aversion

Answer 32

oversensitivity to loss, leading to unwillingness to recognize a loss and move on.

Question 33

KEY TERM:
Anchoring

Answer 33

making decisions according to some perceived benchmark or reference point.

Question 34

KEY TERM:
Framing bias

Answer 34

the tendency to make decisions based on how choices are presented rather than on a comparison of their true values.

Question 35

KEY TERM:
Status quo bias

Answer 35

the tendency to avoid making a decision and sticking with the status quo.

Question 36

KEY TERM:
Nudge

Answer 36

a formulation of the status quo choice intended to shift people to more rational choices when they are prone to status quo bias.