In this chapter you will learn about some typical reasoning problems people have when they make decisions. You will learn that the most important cost to consider is opportunity cost, and that marginal cost should be used when applying the cost-benefit principle. | Some Common Pitfalls for Decision Makers Slide 2 - What is Chapter 2 about? Slide 2 - Pitfall #1: Ignoring Opportunity Costs Slide 2 - Opportunity Cost The value of the next-best alternative that must be forgone in order to engage in a particular activity Slide 2 - What’s “Free”? Using a good we already own is not free could be sold in the marketplace instead possible sales proceeds = opportunity cost Ask yourself – what am I giving up ? “Should I iron my shirt OR watch the end of the movie? Not just, “Should I iron my shirt?” Slide 2 - Opportunity Cost Over Time Pay Now or Pay Later ? You are always better off if you can delay payment – unless you have to pay interest Delayed payments mean $ can be invested (and earn interest) in the meanwhile Opportunity cost of paying now, instead of paying later, is foregone interest Implication: paying a dollar a year from now is not the same as paying a dollar today Slide 2 - Suppose you win the lottery Would you prefer | Some Common Pitfalls for Decision Makers Slide 2 - What is Chapter 2 about? Slide 2 - Pitfall #1: Ignoring Opportunity Costs Slide 2 - Opportunity Cost The value of the next-best alternative that must be forgone in order to engage in a particular activity Slide 2 - What’s “Free”? Using a good we already own is not free could be sold in the marketplace instead possible sales proceeds = opportunity cost Ask yourself – what am I giving up ? “Should I iron my shirt OR watch the end of the movie? Not just, “Should I iron my shirt?” Slide 2 - Opportunity Cost Over Time Pay Now or Pay Later ? You are always better off if you can delay payment – unless you have to pay interest Delayed payments mean $ can be invested (and earn interest) in the meanwhile Opportunity cost of paying now, instead of paying later, is foregone interest Implication: paying a dollar a year from now is not the same as paying a dollar today Slide 2 - Suppose you win the lottery Would you prefer to: Receive $1,000,000 now Receive $50,000 per year for 20 years You could take the $1,000,000 & invest At 5% interest, implies $50,000 per year forever Slide 2 - Time Value of Money A given dollar amount in the future is equal to a smaller dollar amount today Alternatively, a given amount today is equal to a larger amount tomorrow Why ? - Money can be invested in an interest-bearing account in the meantime To pay $10 a year from now (if the interest rate is 10%), you could put about $ in the bank now $ invested now + one year’s interest would cover a payment of $10 in one year’s time Implication: the Present Value of $10 in one year from now is only $ today (at 10%) Slide 2 - Loan interest rates: Rationale Banks pay interest to depositers to compensate them for not using their money right away What could lenders do with the money right away? What is the opportunity cost of their deposit ? could spend it on consumption now might be able to invest it in a real asset
