Short on time? This page is the recap. For explanations, graphs and worked examples, use the full study guide.
Recap
- Rational decision makers compare the benefits and costs of each option and choose the one that leaves them best off.
- Opportunity cost is the value of the next-best alternative given up: one option, not all of them.
- Explicit costs are money paid to others. Implicit costs are the value of your own resources used, such as wages you give up or rent you could have earned.
- Total benefit is utility for a consumer (often shown in dollars) and total revenue for a firm.
- The optimal choice maximises total net benefit.
Key relationships
| Relationship | How to use it |
|---|---|
| Total economic cost = explicit + implicit | List every payment, then add what your own time and resources could have earned |
| Net benefit = total benefit − total cost | Work it out for every option; pick the largest |
| Marginal benefit = change in total benefit; marginal cost = change in total cost | For “how much” decisions, add a unit while MB ≥ MC |
| Accounting view = explicit costs only | Leaves out implicit costs, so it overstates the gain |
| Type of decision | Method |
|---|---|
| “How much” (batches, hours, kilometres) | Totals or marginal steps; both give the same answer |
| “All or nothing” (take the job, build the bridge) | Compare total benefit with total cost |
Assumptions
- Decision makers are rational and want the largest net benefit.
- Benefits and costs can be put in the same unit (usually dollars) so they can be compared.
- Only costs that the decision changes are counted. Money already spent and not recoverable is ignored.
Mistakes to avoid
- Adding the values of all rejected options to get opportunity cost.
- Leaving out implicit costs, especially income given up.
- Choosing the largest total benefit instead of the largest net benefit.
- Stopping at “net benefit is positive” without checking the other options.
- Using marginal steps for an all-or-nothing decision.
- Counting costs you pay whichever option you choose.
Quick self-check
- Ana can go to a concert she values at $40, a match she values at $55, or a film she values at $25. She chooses the match. What is its opportunity cost? ($40, the concert: the next-best option only)
- A 4-day coding workshop costs $300. Ari would otherwise earn $80 a day. He values the workshop at $650. Should he go? (Total cost = 300 + 4 × 80 = $620; net benefit = 650 − 620 = $30, so yes)
- A firm’s total revenue is highest at 8 units. Is 8 units the best choice? (Not necessarily: find where total revenue minus total cost is largest)
Next: practice questions.