Cost of a thing and what people give up to get it

Because people face trade offs making decisions requires comparing costs and benefits of alternative courses of action. In many cases, however, the cost of some action is not as obvious as it might first appear.

Consider for example the decision to go to college. The benefit is intellectual enrichment and a life time of better job opportunities. But what is the cost? To answer this question, you might be tempted to add up the money you spend on tuition, books, room and board. Yet this total does not truly represent what you give up to spend a year in college.

The first problem with this answer is that includes some things that are not really costs of going to college. Even if you quit school, you need a place to sleep and food to eat. Room and board are costs of going to college only to the extent that they are more expensive at college than elsewhere. Indeed, the cost of room and board at your school might be less than the rent and food expenses that you would pay living on your own. In this case, the savings on room and board are a benefit of going to college.

The second problem with this calculation of costs is that it ignores the largest cost of going to college – your time. When you spend a year listening to lecturers, reading textbooks, and writing papers, you cannot spend that time working at a job. For most students the wages given up to attend school are the largest single cost of their education.

The opportunity cost of an item is what you give up to get that item. When making any decision, such as whether to attend college, decision makers should be aware of the opportunity costs that accompany each possible action. In fact, they usually are. College athletes who can earn millions if they drop out of school and play professional sports are well aware that their opportunity cost of college is very high. It is not surprising that they often decide that the benefit is not worth the cost.

Rational People think at the Margin:

Rational people, people whom systematically and purposefully do the best they can to achieve their objectives.

Economists normally assume that people are rational. Rational people systematically and purposefully do the best they can to achieve their objectives given the opportunities they have. As you study economics, you will encounter firms that decide how many workers to hire and how much of their product to manufacture and sell to maximize profits. You will encounter consumers who buy a bundle of goods and service to achieve the highest possible level of satisfaction, subject to their incomes and the prices of those goods and services.

Rational people know that decisions in life are rarely black and white but usually involve shades of gray. At dinner time, the decision you face is not between fasting or eating like a pig but whether to take that extra spoonful of mashed potatoes. When exams roll around your decision is not between blowing them off or studying 24 hours a day but whether to spend an extra hour reviewing your notes instead of watching TV. Economists use the term marginal changes to describe small incremental adjustments to an existing plan of action. Keep in mind that margin means edge so marginal changes are adjustments around the edges of what you are doing. Rational people often make decisions be comparing marginal benefits and marginal costs.

Marginal changes small incremental adjustments to a plan of action.

For example, consider an airline deciding how much to charge passengers who fly standby. Suppose that flying a 200 seat plane across the United States costs the airline $100,000. In this case the average cost of each seat is $ 100,000 / 200 which is $500. One might be tempted to conclude that the airline should never sell a ticket for less than $500. In fact, however the airline can raise its profits by thinking at the margin. Imagine that a plane is about to take off with ten empty seats, and a standby passenger waiting at the gate will pay $300 for a seat. Should the airline sell the ticket? Of course it should. If the plane has empty seats, the cost of adding one more passenger is minuscule. Although the average cost of flying a passenger is $500, the marginal cost is merely the cost of the bag of peanuts and can of soda that the extra passenger will consume. As long as the stand by passenger pays more than the marginal cost, selling the ticket is profitable.

Marginal decision making can help explain some otherwise puzzling economic phenomena. Here is a classic question: Why is water so cheap, while diamonds are so expensive? Humans need water to survive, while diamonds are unnecessary; but for some reason, people are willing to pay much more for a diamond than for a cup of water. The reason is that a person’s willingness to pay for any good is based on the marginal benefit that an extra unit of the good would yield. The marginal benefit, in turn, depends on how many units a person already has. Although water is essential, the marginal benefit of an extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large.

A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost. This principle can explain why airlines are willing to sell a ticket below average cost and why people are willing to pay more for diamonds than for water. It can take some time to get used to the logic of marginal thinking.