Unit 1 · Topic 1.5

Cost-Benefit Analysis

A choice's total cost includes explicit costs, the money you pay, and implicit costs, the value of your own time and resources that you give up.

Practice 1: Principles and Models

Part 1 · Hook

Why this matters

Rosa can spend the summer running her own lawn-care business or keep her $4,000 job at a garden center. On paper the business takes in $6,500 and costs $1,600 for the mower, gas and flyers, so it looks like a $4,900 win. But that leaves out the paycheck she gives up. Count every cost, the ones she pays and the ones she gives up, and the decision looks much closer.

Part 2 · Before you start

What this builds on

Part 3 · Prerequisite check

Quick check before you start

1. The opportunity cost of a choice is

  1. the value of the next-best alternative given up
  2. the money you pay for it
  3. the sum of every alternative
  4. zero when nothing is paid
Show the answer

Only the next-best alternative counts.

  • Correct: the value of the next-best alternative given up:
  • the money you pay for it:
  • the sum of every alternative:
  • zero when nothing is paid:

2. A firm uses its own building instead of renting it out for $500 a month. Using it

  1. gives up $500 a month
  2. costs nothing, because the firm owns it
  3. costs the building's purchase price every month
  4. earns the firm $500
Show the answer

The rent it could have earned is the next-best use.

  • Correct: gives up $500 a month:
  • costs nothing, because the firm owns it:
  • costs the building's purchase price every month:
  • earns the firm $500:

Part 4 · See it

See it first

A bar chart of total benefit and cost for 0 to 5 guitar lessons a month at $25 a lesson; net benefit is largest, $45, at 3 lessons. Invented data.
Total benefit and the cost of 0 to 5 guitar lessons a month at $25 a lesson. Net benefit is largest, $45, at 3 lessons, even though total benefit keeps rising. Invented data for practice. LevlPrep original diagram.

Part 5 · Step by step

How it works, step by step

  1. You list every cost of a choiceyou include explicit costs (money paid) and implicit costs (the value of what you give up)
  2. You add explicit and implicit costsyou get the full economic cost of the choice
  3. You subtract the economic cost from the total benefityou get the net benefit
  4. You compare the net benefit of each optionyou choose the option with the largest net benefit, not the largest total benefit

Part 6 · Key ideas

Key ideas

  • Explicit costs are money payments. Implicit costs are the value of resources you already own or time you give up, with no money paid.
  • Economic cost = explicit costs + implicit costs. Leaving out implicit costs makes a choice look better than it is.
  • Total benefit is what a choice gives you: for a consumer, the satisfaction of using a good; for a firm, the money it takes in from sales (its revenue).
  • Net benefit = total benefit - total cost. The best choice has the largest net benefit.
  • Some choices are all or nothing (compare totals); others are about how much (the next topic looks at one more unit at a time).

Part 7 · Misconception

A common mistake

The wrong idea: The best number of guitar lessons is 5, because 5 lessons give the most total benefit.

What actually happens: The fifth lesson adds more cost than benefit. Net benefit, total benefit minus total cost, is largest at 3 lessons ($120 - $75 = $45).

Part 8 · Check yourself

Check yourself

Exam-style questions. Anything you miss goes into your review queue.

1. Which of these is an implicit cost of running a business?

  1. The rent paid for the shop
  2. Wages paid to employees
  3. The salary the owner gives up
  4. The bill for electricity
Show the answer

An implicit cost involves no payment: it is the value of something the owner gives up, such as a salary from another job.

  • The rent paid for the shop: Rent paid is a money payment: explicit.
  • Wages paid to employees: Wages paid are explicit.
  • Correct: The salary the owner gives up: Right: no money changes hands, but something is given up.
  • The bill for electricity: A bill paid is explicit.

Data

Rosa's summer lawn-care business

Rosa's numbers for one summer of running her own business (invented data for practice)
ItemAmount ($)
Money from customers6,500
Mower rental1,200
Gas300
Flyers100
Pay she gives up at her garden-center job4,000
Rent she gives up by using the family truck instead of renting it to a neighbor500

2. What are Rosa's explicit costs for the summer, in dollars?

Type a number ($). A four-function calculator is allowed, as on the exam.

Show the answer

Explicit costs are the money she pays: mower 1,200+1{,}200 + gas 300+300 + flyers 100=1,600100 = 1{,}600 dollars.

  • Answer: 1600 $

3. What is Rosa's net benefit from running the business, counting every cost, in dollars?

Type a number ($). A four-function calculator is allowed, as on the exam.

Show the answer

Net benefit = total benefit - (explicit + implicit costs) =6,500−(1,600+4,500)= 6{,}500 - (1{,}600 + 4{,}500)=400= 400 dollars.

  • Answer: 400 $

Data

Guitar lessons: total benefit and total cost

Total benefit to Jamal (in dollars he would pay) and total cost of guitar lessons at $25 each (invented data for practice)
Lessons per monthTotal benefit ($)Cost of lessons ($)
000
15025
29050
312075
4140100
5150125

4. How many lessons a month give Jamal the largest net benefit?

  1. 5
  2. 4
  3. 1
  4. 3
Show the answer

Net benefits are 0, 25, 40, 45, 40 and 25 dollars. The largest, $45, is at 3 lessons.

  • 5: Five lessons give the most total benefit but a net benefit of only $25.
  • 4: Four lessons give $40, less than $45.
  • 1: One lesson gives $25.
  • Correct: 3: Right: $120 - $75 = $45.

5. Two friends compare a business idea. One subtracts only the money they will spend; the other also subtracts the pay they give up. Who measures the choice correctly?

  1. The first friend, because money spent is what counts
  2. Both, because the two results come out the same
  3. The second friend, because implicit costs are real costs
  4. Neither, because benefits should not be compared with costs
Show the answer

The total cost of a choice includes what you give up. Leaving out implicit costs overstates the net benefit.

  • The first friend, because money spent is what counts: Pay given up is a cost even though no money is spent.
  • Both, because the two results come out the same: Adding implicit costs changes the result.
  • Correct: The second friend, because implicit costs are real costs: Right: count explicit and implicit costs.
  • Neither, because benefits should not be compared with costs: Comparing benefits with costs is exactly how choices are judged.

Part 9 · Summary

Summary

A choice's total cost includes explicit costs, the money you pay, and implicit costs, the value of your own time and resources that you give up. Its total benefit is the satisfaction it gives a consumer or the revenue it brings a firm. Net benefit is total benefit minus total cost, and the best choice is the one with the largest net benefit. Ignoring implicit costs, or chasing the largest total benefit instead of the largest net benefit, leads to the wrong choice.

Part 10 · Up next

What comes next

Part 11 · Connections

Connections

Question set for this topic