Decision Making Flashcards
What does decision making depend on?
Comparing costs and benefits; the quality of decisions depend on how well the costs and benefits are understood
Define explicit cost
A cost that requires an outlay of money (measures value of money)
Define implicit cost
A cost that doesn’t require an outlay of money; it’s measured by the value of benefits that are lost (e.g. Wages lost due to being a student)
How is accounting profit and economic profit calculated?
Accounting Profit = Revenue - Explicit Cost
Economic Profit = Revenue - Explicit Cost - Implicit Cost
Define capital
The total value of an individual’s assets
The implicit cost of capital is 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)
Define marginal cost
The additional cost incurred by producing one more unit of that good or service
Define marginal benefit
The additional benefit derived from producing one more unit of a good or service.
Define optimal quantity
The largest quantity at which the marginal benefit is greater than or equal to marginal cost
Give 3 reasons why somebody may choose a worse payoff
- Concerns about fairness - providing for others sometimes defeats self interests
- Bounded rationality - making a choice close to the highest possible profit
- Risk aversion - willingness to sacrifice some economic payoff in order to avoid a potential loss
Why may somebody make an irrational decision (4)?
- Misperceptions of opportunity costs - if all of the costs aren’t understood then a rational choice cannot be made
- Overconfidence - nonprofessional investors have worse chances than professional investors
- Unrealistic expectations about future behaviour - most are overly optimistic about future behaviour
- Counting money unequally (mental accounting)
- Loss aversion - an oversensitivity to loss that leads to unwillingness to recognise a loss and move on
- Status quo bias - the tendency to avoid making a decision all together
Define mental accounting
The habit of mentally assigning money to different accounts so that some money is worth more than other money
Give 3 ways in which rational consumers choose what to spend money on
- All goods have utility/value
- There is no saving - consumers spend all income and ignore future consumption
- Marginal utility diminishes over time
Define marginal utility
The change in utility from consuming an additional unit
Define diminishing marginal utility
Each additional unit of good adds less to utility than the previous unit
How can the marginal utility be compared to the price?
The MU must be compared to the price for all goods then adjust spending towards the goods that give more MU per pound
