Chapter 9: Decision Making by Individuals and Firms

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Imagine this scenario.

Two siblings,

Mackenzie and Adam McQuade.

Both graduate college, similar degrees, but totally different job markets.

Adam graduates back in 2010, unemployment's nearly 10%.

He's really struggling.

Tough time.

Yeah, exactly.

But then Mackenzie, just four years later, 2014, unemployment's way down 6 .1 % and she gets a job right away.

It's a stark difference, isn't it?

And their stories, well, they really show how these big economic shifts affect everyday choices.

Like Adam may be thinking about more school when jobs are scarce.

Totally.

And that's really what we're diving into today, isn't it?

The whole art and science behind making, well, optimal economic decisions.

Exactly.

We're going to unpack the core ideas, looking at how individuals, you know, people like you and firms make choices and crucially why sometimes those choices aren't, let's say, perfectly rational in the textbook sense.

But maybe predictably irrational.

Predictably so, often.

Yeah.

This is basically your shortcut to getting a solid handle on this stuff, whether you're prepping for an econ class or just trying to make smarter choices day to day.

Okay, let's do it.

So today,

costs,

benefits, what really counts?

Then these different decision types like either or versus how much.

And marginal analysis, that's a big one.

Right, that powerful tool.

Plus, we'll hit some costs why they're so tricky.

And hard to ignore.

Definitely.

And then behavioral economics, which explains why we sometimes, well, mess up.

And even a quick look at decisions over time using present value.

It's a packed agenda, but it all boils down to making better choices.

And that starts with accurately identifying costs and benefits.

Sounds basic, right?

Seems simple enough.

But it's where things often go wrong.

The absolute core idea here is opportunity cost.

Remember that one.

Because resources are scarce, the true cost of anything isn't just the price tag.

It's what you have to give up to get it.

Exactly.

Like choosing more school, the cost isn't just tuition fees.

It's also the salary you would have been earning if you'd taken a job instead.

That's the opportunity cost.

Precisely.

And this leads us to explicit costs versus implicit costs.

Explicit costs are, well, explicit.

Money actually leaves your hand, tuition, books, a laptop for school.

Things you get a bill for.

Pretty much.

And implicit costs, though.

That's different.

No money changes hands directly.

It's the value of the benefits you forgo.

So that salary you didn't earn, that's a classic implicit cost.

And I bet people often forget about those implicit costs, right?

Focusing just on the tuition bill.

That's the common mistake.

And often the implicit costs are way bigger.

It's a crucial insight.

So how much bigger are we talking?

Well, think about a year of college.

Maybe the explicit costs tuition, books add up to, say, $9 ,500, just hypothetically.

But the implicit costs that foregone salary could easily be $35 ,000, maybe more.

Wow.

So the real opportunity cost for that year isn't $9 ,500, it's over $44 ,000.

And the implicit part is, like, more than three times the explicit part in that example.

If you ignore that, you're making decisions based on incomplete information.

And that explains the surge in college applications back in 2010 during the recession.

Exactly.

The job market was weak, so the salary you were giving up by going to school, the implicit cost was lower.

Suddenly, the total opportunity cost of education dropped, making it a much more attractive option for people like Adam.

That makes perfect sense.

Okay, building on that, economists talk about accounting profit versus economic profit.

How does that fit in?

It's another vital distinction for optimal decisions.

Okay.

Let's go back to Adam.

He's weighing two choices,

a two -year pharmacology program or just working for those two years.

Okay.

Now, if he gets the degree, let's say his future lifetime earnings jump by $100 ,000 in today's value.

$600K versus $500K.

The explicit cost tuition, maybe some loan interest, total $44 ,000.

So, simple math.

$100 ,000 benefit minus $44 ,000 cost.

Gives you an accounting profit of $56 ,000.

Looks pretty good, right?

Yeah.

Seems like a clear win for grad school.

Ah, but wait.

For the best decision, Adam needs his economic profit.

That's revenue minus the total opportunity cost, explicit and implicit costs.

Okay.

So, what's the implicit cost here?

It's the salary he would have earned during those two years in school.

Let's say that's $57 ,000.

Right.

Now, factor that $57 ,000 implicit cost in,

his $56 ,000 accounting profit turns into an economic loss of negative $1 ,000, $100 ,000 revenue, $44 ,000 explicit $57 ,000 implicit and negative $1 ,000.

So, economically speaking, he's actually better off not going to grad school.

In this scenario, yes.

He's better off taking the job right now.

That's why economists always focus on economic profit.

It captures the true cost of using your resources.

That's a really powerful distinction.

And it's not just about salary, is it?

What if he didn't need a loan?

Say, he used an inheritance to pay the $40 ,000 tuition.

Great point.

Even using your own money, your capital, has an opportunity cost.

That $40 ,000 inheritance, if not spent on tuition, could have been invested, maybe earning interest, let's say $4 ,000 in foregone interest.

Ah, so that becomes another implicit cost.

Exactly.

It's the implicit cost of capital.

The income of your capital could have generated elsewhere.

So, the impact on his economic profit calculation is essentially the same.

You always have to account for what else you could have done with your resources, whether it's time or money.

Okay, got it.

Costs, benefits, economic profit check.

Now, let's switch gears to the types of decisions, either or versus how much.

Right.

An either or decision is choosing between two distinct options, like Adam's choice.

Grad school or are a job.

You pick one path.

And the rule here seems simple enough.

It is.

The principle of either or decision making is,

choose the option with the positive economic profit.

Or, if both are positive, the one with the higher economic profit.

So, for Adam, the job had a $1 ,000 economic profit relative to school, which had a naggish $1 ,000 economic profit.

Easy.

Take the job.

Precisely.

And where do people go wrong with these?

Often it's back to ignoring those implicit costs, especially when using their own time or capital.

Small business owners, for example, might think they're making a profit, but forget to count the value of their own hours worked.

What if there are like three or more options?

Does the either or thing still work?

Yep, absolutely.

You just do it sequentially, compare option A and option B,

pick the better one, then compare that winner to option C and so on.

You keep narrowing it down to find the single best choice based on economic profit.

It's interesting how things like, say, Airbnb change these calculations.

Oh, definitely.

Think about that spare room you have.

Before space sharing sites, the opportunity cost of keeping it empty, essentially, the cost of your privacy might have seemed low.

Right.

Maybe you just store junk in there.

Exactly.

But now, especially if you're in a popular area, that room could be generating income every night via Airbnb or similar platforms.

That potential income drastically increases the opportunity cost of not renting it out.

So the cost of privacy goes way up, making the either or decision rent it out or keep it private tilt towards renting.

Precisely.

It's a great real world example of shifting opportunity costs influencing decisions.

Okay, so that covers either or.

What about the how much decisions?

Like how many coffees should I buy or how many hours should I study?

Right.

These are about quantity, how much of an activity to do.

And for these, the key tool is marginal analysis.

Marginal, meaning at the edge or one more.

You got it.

Marginal analysis involves comparing the benefit of doing just a little bit more of something, one more hour of studying, one more employee hired with the cost of doing that little bit more.

So marginal benefit versus marginal cost.

Exactly.

The marginal benefit is the additional benefit from one more unit.

The marginal cost is the additional cost from one more unit.

Let's use Alexa deciding how many years to study computer science.

Okay.

So each extra year has costs like tuition, which might be the same each year.

That's an explicit cost.

Right.

But her implicit cost, the salary she's giving up, likely increases each year because she's becoming more skilled and could command a higher starting salary.

Ah, so her total cost goes up each year.

And the additional cost for year two might be higher than for year one.

Spot on.

That means her marginal cost is increasing.

Each additional year of study costs more than the previous one.

This is common.

It's called increasing marginal cost.

If you were to graph this with years of schooling on the horizontal axis and cost on the vertical,

the marginal cost curve would slope upwards.

Okay.

Makes sense.

What about the benefit side?

Well, her total lifetime earnings generally increase with more schooling, but the additional benefit from one more year, the marginal benefit often decreases.

Why is that?

Think about it.

The jump in earnings from having say one year of college versus none might be huge, but the jump from completing a fifth year versus already having four might be smaller.

Right.

Diminishing returns kind of.

Exactly.

This is decreasing marginal benefit.

Each extra unit adds less benefit than the one before.

So a marginal benefit curve typically slopes downwards.

So we have an upward -sloping marginal cost curve and a downward -sloping marginal benefit curve.

How does Alexa use these to pick the optimal number of years?

This is the core of it.

She compares the marginal benefit, MB, and marginal cost, MC, for each potential additional year.

So year one, is MB greater than MC?

If yes, do it.

Year two, is MB greater than MC?

Keep going.

As long as the marginal benefit of an additional year is greater than or even equal to the marginal cost, that year adds to her overall net gain, her economic profit from schooling.

But eventually the cost of one more year might outweigh the benefit.

Right.

Maybe for year four, the marginal cost is $50 ,000, but the marginal benefit is only $40 ,000.

Doing that fourth year would actually make her worse off overall compared to stopping at three.

So the optimal quantity is the last year where the benefit was still greater than or equal to the cost.

Precisely.

It's the largest quantity number of years, in this case, at which MBEs equals MC.

That's the point that maximizes her total profit from education.

Graphically, it's where the MB and MC curves intersect, or the last point where MB is above MC.

And this profit -maximizing principle of marginal analysis applies broadly.

Absolutely.

It explains why people went back to school in the recession.

Lower MC made more years optimal.

It explains house sizes, where land is cheap.

Low MC for square footage.

Houses are bigger.

Think about farmers deciding how much fertilizer to use, or stores deciding how big to build.

It's all marginal analysis.

Is there a difference when we apply this to, say, buying things versus a business producing things?

A key difference for consumption decisions is the budget constraint.

As a consumer, buying more of one thing usually means you have to buy less of something else because your income is limited.

Producers like Alexa deciding on schooling or a firm deciding on output can often borrow capital, so they aren't necessarily constrained by current income in the same immediate way.

Got it.

Okay.

Now for something that really trips people up, sunk costs.

Ah, yes.

Sometimes the key to good decisions is knowing what to ignore.

And sunk costs fall into that category.

Definitely.

A sunk cost is a cost that's already been incurred and is non -recoverable.

It's money or time or effort that's gone, no matter what you do next.

And the rule is?

Ignore them.

Sunk costs are irrelevant to future decisions.

Okay.

Give us that classic example, the car repair one.

Right.

Let's say you spend $250 on new brake pads.

Your mechanic then says, uh -oh, the whole system is shot.

It'll be another $1 ,500 to fix.

Meanwhile, you see a similar used car for sale for $1 ,600.

So do you spend the $1 ,500 or the $1 ,600?

That's the relevant choice.

The mistake is thinking, I already spent $250, so the repair is really $750, making the new car cheaper.

That's the sunk cost fallacy.

Because the $250 has gone anyway.

It doesn't matter to the current decision.

Exactly.

It's sunk.

Your choice now is just between spending $1 ,500 more on the old car or $1 ,600 on the new one.

You ignore the $250.

But psychologically, that's really hard.

We hate feeling like we wasted money.

Oh, it's incredibly hard.

We're wired to feel losses keenly.

But the rational economic choice is clear.

Ignore sunk costs.

Think about the biotech industry.

You mentioned them.

They pour billions into drugs that fail.

Billions.

Those are massive sunk costs.

But when deciding whether to fund the next potential drug, rational investors ignore those past losses.

They only look at the potential future costs and benefits of the new project.

The past failures are irrelevant to the new decision.

Which brings us neatly into behavioral economics.

Because, let's face it, we aren't always those perfectly rational actors economic models assume we are.

Not even close sometimes.

Behavioral economics blends economics and psychology to understand how people actually make decisions, flaws and all.

But first, let's be clear.

Sometimes, choosing something that results in less money is perfectly rational.

Okay.

When is it rational to not maximize money?

Four key situations.

First, concerns about fairness.

We tip servers, we give gifts, we sacrifice money to maintain social norms or feel fair.

Makes sense.

Second, non -monetary rewards.

Especially once basic needs are met, people value experiences, leisure time, work that aligns with their values, maybe more than just maximizing income.

Think backpacking versus buying more stuff.

Right.

The value of an extra dollar goes down.

Diminishing marginal utility, exactly.

Third,

bounded rationality.

Finding the absolute perfect choice takes time and mental energy.

Often, we make a choice that's good enough rather than optimizing perfectly because the effort of optimizing isn't worth it.

Like picking a decent lunch spot quickly.

Satisfying, not maximizing.

You got it.

And fourth, risk aversion.

Most people are willing to give up some potential gain to avoid a potential loss.

Buying insurance is a rational act of risk aversion.

Like those homeowners doing jingle mail, sending keys back to the bank when they were underwater on their mortgage.

That was rational, right?

Even though it involved walking away from past payments.

Absolutely rational.

They correctly identified their past payments as sunk costs.

The relevant comparison was the future cost of staying, high mortgage payments on an asset worth less, versus the future cost of leaving, renting, potentially cheaper.

It was often economically smarter to cut their losses.

But then there are the times where just irrational, and predictably so.

Yes, predictably irrational.

Behavioral economists have identified several common biases.

First, misperceiving opportunity costs, often involving that sunk cost fallacy.

Again, like sticking with that failing course because you paid tuition.

Been there.

Second, overconfidence.

We tend to think we're better or more knowledgeable than we are.

Students thinking a thesis will take less time.

Amateur investors thinking they can beat the market.

Guilty again.

Third, unrealistic expectations about future behavior.

I'll definitely start exercising tomorrow.

Procrastination is a big one.

That's why things like automatic savings plans are effective.

They take the future decision out of our unreliable hands.

What else?

Counting dollars unequally, or mental accounting.

Treating a tax refund differently from regular salary, or spending more easily with a credit card than cash.

A dollar should be a dollar, but we often don't treat it that way.

Interesting.

Then there's loss aversion.

We feel the pain of a loss about twice as much as the pleasure of an equivalent game.

This makes us hold on to losing investments too long, for example.

It's very related to ignoring sunk costs.

And how things are presented.

Framing bias.

Yep.

$9 .99 versus $10.

75 % lean versus 25 % fat.

Same thing.

Different feeling.

Retailers use anchoring too.

Showing a high original price next to the sale price makes the sale price seem better.

And finally.

Status quo bias.

The tendency to just stick with the default option because it's easier than making an active choice.

Think about retirement plan enrollment making it opt out rather than opt in.

Massively increases participation.

Using defaults like this is a type of nudge.

So if we're prone to all these biases, why do standard economic models still rely so heavily on rationality?

Good question.

Several reasons.

One, the rational models often still get pretty good predictions, especially in aggregate market behavior.

Two, market forces can punish irrationality over time.

Businesses that make bad decisions tend to fail.

Three, it provides a simpler, more tractable starting point for analysis.

Even behavior models often start with the rational framework and then add the specific biases.

It's like a necessary simplification, but we need to be aware of its limits.

That Dan Irelie procrastination study you mentioned sounds like a perfect example of predictable irrationality in action.

It really is.

He found students performed best when given strict, evenly spaced deadlines by the professor.

They did worse when they had total flexibility.

Crucially, students who could choose their own deadlines did better than the totally flexible group, but only if they recognized their tendency to procrastinate and set binding deadlines for themselves.

It shows we can use tools to overcome our biases if we're aware of them.

Fascinating stuff.

Okay, one last area to touch on briefly.

Decisions involving time.

Comparing costs and benefits that happen at different points.

Right.

Very important for things like education or business investment.

How do you compare a cost today with a benefit 10 years from now?

The answer is present value.

Discounting the future back to today.

Exactly.

Present value tells you how much money you'd need today to generate a specific amount in the future given an interest rate.

So if the interest rate is 5%, getting $1 ,000 in one year is equivalent to having about $952 today.

$1 ,000.

We discount future values back to the present to make them comparable.

And for projects with costs and benefits over many years.

You calculate the present value of all the expected future revenues and all the expected future costs.

Subtract the present value of costs from the present value of revenues and that gives you the net present value.

NPV.

When comparing projects, you choose the one with the highest NPV.

It's a standard tool in finance and business.

Wow, okay, we covered a huge amount of ground there.

We really did.

From understanding true costs explicit and those sneaky implicit ones through economic profit either or choices and then the power of marginal analysis for how much decisions.

Plus tackling sunk costs, which are so easy to fall for and then diving into all those fascinating quirks of human behavior with behavioral economics and finally present value for time -based choices.

It all connects back to making more informed, more optimal decisions.

And these concepts, they aren't just for economists or exams.

They are genuinely useful tools for navigating decisions in your own career, your finances, really everyday life.

Absolutely.

Understanding this stuff really can help you make better choices.

So let's leave our listeners with something to think about.

Considering all those predictable ways we can be irrational.

What's one practical step, just one thing you can do today to maybe nudge your future self towards a slightly more rational economic decision?

That's a great question to ponder.

Think about it.

Apply these ideas.

You've definitely got the tools now.