Microeconomics for Managers

Textbook for Managerial Economics and Business

Strategy
Economics 3551
Winter Quarter 2013

By
David J. St. Clair
Professor
Department of Economics
California State University, East Bay

2013

Table of Contents

Chapter 1 Introduction: Economics and Decision Making 3

Chapter 2 The Goal of the Firm and its Environment .. 35
Chapter 3 The Many Faces of Competition . 49
Chapter 4 - The Firms Vertical and Conglomerate Boundaries . 64
Chapter 5 - Demand and Elasticity .. 91
Chapter 6 - Price Discrimination ..... 126
Chapter 7 Horizontal Issues: Costs in the Short Run .. 137
Chapter 8 - Market Structure Analysis ... 147
Chapter 9 - Barriers to Entry ... 171
Chapter 10 - Unit Costs in the Long Run ... 188
Chapter 11 - Searching for Economies of Scale .. 195
Chapter 12 - Countering Diseconomies of Scale . 210
Chapter 13 - A Final Look at Competition: Antitrust Policies .. 226

David J. St. Clair

Microeconomics for Managers

Chapter 1
Introduction: Economics and Decision Making
Economics is a social science concerned with how people go about
providing for their material well-being. As such, economics often focuses on
business activity. Indeed, economists were studying business activity decades
before the study of business (and business schools) emerged as a separate
academic inquiry.
The systematic study of economics began in the 18th century under the
term political economy. This name was changed to economics in the late
nineteenth century in order to distinguish the field from Marxist political economy.
Today, the term political economy continues to be associated with Marxism;
unless you are a comrade-in-training, it is probably best to stick with the new
name.
After the 1930s, economics split into two distinct (but still related) fields of
study: microeconomics and macroeconomics. Macroeconomics grew out of the
crippling impact of the Great Depression of the 1930s. In macroeconomics, the
focus is on how the overall (or aggregate) economy functions. Do we have full
employment or do we have unemployment? Are prices stable, or do we have
inflation? Are we growing or stagnating? Do non-market economic systems
perform better or worse than market economic systems? These are all primarily
macroeconomic questions.
Microeconomics is the branch of economics that focuses on how
individuals and business firms make decisions in markets. Microeconomics
attempts to explain how markets work, and why they might not work so well.
Microeconomics, like economics in general, has usually been policy-oriented,
that is, the emphasis has usually been on analyzing market outcomes with an
eye toward formulating the firms business strategy and/or public policies. For
example, should markets be allowed to function free of government control, or
should markets be closely regulated by government? Managerial Economics and
Business Strategy is a course in microeconomics taught with the business
manager in mind. As such, it should seek to present microeconomic concepts
and analysis in a manner most useful for business professionals.

A Few Words about the Structure and Format of this Course

This course and text will probably look a bit different from the economic
courses and texts that you have been used to seeing; there are few graphs,
equations, models, or derivations. This is not an oversight or omission it is by
design. This course will primarily feature microeconomic concepts presented in a
narrative format and supplemented with short real world cases and examples.
This approach was developed in response to one paramount question:
What do business men and women need to know about microeconomics? This is
actually a variation on a more fundamental question that should underlie all
courses: What should students know about a subject and how should they know
it?
My answer to this question is multi-facetted. First, this course never
forgets that it is designed for business students. Microeconomic theories and
concepts will be presented in a manner that is most useful to those who will
primarily be users of microeconomics rather than practitioners. This certainly
includes most managers and business people. (This should also include most
economics majors, including those destined for graduate school in economics;
tragically, too many economics majors end up mastering only stylized or abstract
theoretical economic models.
Second, this course is built on the premise that how you know
microeconomics is just as important as what you know. What kind of
microeconomics will be most useful for business managers and owners?
Unfortunately, stylized and abstract models seldom have much relevance to
managers and overly formal models and graphs are often more distracting than
helpful. For business people, models, graphs, and rigorous proofs are not very
useful on the job. Your colleagues on the trading floor or in a business meeting
are going to laugh or get angry if you start drawing graphs or lecturing about
models. To be sure, models, graphs, and proofs have their place in academic
economics, but they are not very useful here. We will go to great lengths to avoid
this problem. If you have found graphs and formal models confusing, take heart
in the knowledge that there is nothing in a graph that cannot be readily
communicated in straight-forward narrative English. (However, the converse is
often not the case.)
This text embraces this approach. The focus is on a rigorous narrative
exposition of economic concepts and issues that will hopefully be most useful to
business managers. This does not mean that the material presented in this
manner is any less rigorous; it simply means that there is a different emphasis.
There will be less derivation, less model building, and less graphs. There will be
more emphasis on practical microeconomic policy issues and solid narrative
exposition. Most important, all of the assignments and exams feature the same
approach. Assignments and exams will test your microeconomic knowledge in a
narrative format without the need for graphs, formal proofs, formal derivations, or
elaborate model building.

Finally, the class and text seek to illustrate economic concepts with short
examples and cases. It is usually easier to understand a concept when it is
grounded in a real-world example. However, we will avoid long case studies
because these often obscure the point rather than highlight it. If the point of an
example or mini case is not readily apparent, you have either missed something,
or I have not done my job well.

A Simple Suggestion for Testing Your Knowledge

The approach described above lends itself to a very simple way of testing
your knowledge of applied microeconomics. To see if you have acquired the
microeconomic understanding needed to excel in the business world, try this
simple test: Say it. Say it out loud. Shout it or whisper it. Tell it to a classmate or
tell it to yourself or tell it to a friend or lover (but be careful, you can lose friends
and lovers this way). The point is that microeconomics in the business world will
only be useful if you can verbalize it. If you cannot verbalize it, you can not use it
or access it when it counts. To me, this means that you do not really know it.
The reason why this is such a good test of your knowledge stems from a
curious fact of human nature. When you read something and encounter a word
or concept that you do not understand, your mind can simply skip over it. This is
also true of concepts that you know something about, but are still a bit vague or
fuzzy on. For example, you may read something that seems reasonable, but you
are still not completely sure about it. The mind will move on and most people will
be content with this vague understanding. But do you know it?
The answer to this question is a resounding no; you do not know it and
you will quickly discover this when you try to say it. Reading and listening are
passive, but speaking is not - speech does not come when the concept is vague
or fuzzy. When you dont know it but try to say it, you stop; speech wont jump
over the fuzzy part. This is why saying it is such a good test of your
understanding and why saying it is the ultimate study tip.

Getting Started: Centuries of Human History in a Few Paragraphs

Discussions without a bit of background and context are seldom
productive. What follows in this section is a very brief look at the (not-so) good
old days. The goal is to put the modern economy and economics in context.
Before the capitalist era, economies all around the world were
overwhelmingly agrarian. Most people tilled the soil and the economy was
usually organized around the village. The village economy was in turn structured
according to tradition. Tradition was the time-honored way of doing things that
had been passed on through the generations. Tradition dictated who did what

and when, as well as who got what and why. People were seldom asked to make
choices, but they were constantly required to conform to tradition.
If you had traveled around in the pre-capitalist world, you would have
encountered societies with very different traditions, languages, costumes, diets,
religions, and customs. But while these societies may have all looked very
different on the surface, at their cores, they were all quite similar - tradition ruled
in each. In addition, all traditional economies have had remarkably similar
structures and features. The following have been typical of just about all
traditional economies:
1. Agriculture predominated
Through history, village economies have conformed to what economic
historian Carlo Cipolla termed The 90 10 Rule. According to Cipolla, village
societies always had about ninety percent of the population directly employed in
agriculture. The vast majority of workers had to work in agriculture due to their
very low (by modern standards) productivity. It took ninety percent of workers
tilling the soil in order to grow food for themselves as well as for the 10 percent
crust that worked outside of agriculture. The 10% crust included the educated,
well-fed, upper classes as well as craftsmen, merchants, soldiers, government
officials and members of the clergy. And the crust was quite thin; these citydwellers were little more than small scattered islands in a sea of peasants
2. Short, but not Sweet
The village economy was usually a place of too little too little food, too
little shelter, too little clothes (and no underwear), and too little years. In the notso-good-old days, men usually had a life expectancy in their mid-thirties; women
lived much shorter lives (child bearing took a terrible toll). The masses were
skinny and the rich were fat; fat was beautiful and the upper classes took great
care to differentiate themselves from the great unwashed through fashions such
as ridiculously long finger nails (i.e., proof that one never touched manual labor).
3. Markets were Few and Far Between
Tradition ruled the lives of peasants and markets were limited to the cities
and towns scattered across the sea of peasants. Most peasants might engage in
only a few market transactions during their lives; many none at all. And where
markets functioned, they were usually tightly regulated by suspicious officials. In
addition, merchants were not tradition-bound and were sometimes very upwardly
mobile. This drew the ire of the upper classes and put them in an awkward
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position; the upper classes enjoyed the products and variety that markets
brought them, but it was difficult for them to watch uppity merchants getting richer
than their social superiors. Distrust of markets and merchants has usually been a
feature of pre-capitalist economies (and many capitalist economies as well).
4. Stability, not Growth
Traditional economies and societies were structured for stability and
survival, not change and development. Equally important, people were not
accustomed to economic progress, nor did they expect economic progress. In
fact, the notion of a "good life to a peasant usually meant an absence of any
change (i.e., a good life was a life where nothing bad happened). In this world,
one generation took over from another, doing essentially the same things that
their parents did. They in turn sought to pass on their traditional lifestyle to the
next generation. Outside of the upper ranks of the nobility, people in traditional
economies seem to never have embraced the idea that things could get better for
themselves or for future generations; maintaining the status quo was thought to
be as good as it gets.
5. A World without Economists
In traditional economies, there was no systematic economic inquiry, nor
much interest in economic topics. The reasons for this largely reflect the features
discussed above; there was little need for or interest in economics because:
First, with little or no market activity, there was little need to understand markets.
Second, with tradition governing these economies, their workings were fairly
obvious. A casual observer spending a few days in a village could easily
understand the workings of the village economy. However, this has never been
the case with markets. Markets have always confused people, both educated as
well as uneducated. Markets have been so confusing because on first inspection,
it always appears that no one (or nothing) is in control. Market activity appears to
be chaotic, free, unstructured, unregulated, unplanned, and selfish. Markets have
been especially confusing to religious and secular authorities, and what people
do not understand, they mistrust. Third, since nothing much changed for the
better in traditional economies, there appeared to be little need for an economic
development strategy. Fourth, educated people in the crust went to great lengths
to separate themselves from the great unwashed masses and took virtually no
interest in the affairs of working people. For all of these reasons, a systematic
study of economics was inconceivable.

The Emergence of Markets and Economics

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In the 18th century, Great Britain became the first country to break the
90-10 rule. This resulted from a revolution in agriculture that began in the 17th
century which dramatically increased productivity. The Agricultural Revolution
was followed by a further quickening of economic activity in the British Industrial
Revolution after 1750. As agricultural output increased dramatically, the share of
agricultural output and employment in agriculture began a relentless decline.
Today, agriculture employs less than 2 percent of workers in most developed
economies.
At the same time, markets expanded, industrial output surged, urban
areas grew, and the population exploded. From Britain, industrialization spread to
Western Europe and to areas of European settlement. On the other hand,
traditional village economies (or hybrid village economies) continued to persist in
most of the underdeveloped parts of the world today, with a large development
gap opening between the developed and underdeveloped parts of the world.
Today, some underdeveloped economies are in the midst of similar rapid
transformations; others however, are virtually dead in the water (i.e., they are
undeveloped and not going any where).
The successes of European economies lead to the development of
economics as a systematic science. The creation of economics was primarily
driven by the need to explain how markets worked, and by growing
dissatisfaction with mercantilist economic development policies. In 1776, Adam
Smith published An Inquiry into the Nature and Causes of the Wealth of Nations.
(Abbreviated title: The Wealth of Nations.) This was one of the first books
devoted to systematic economic inquiry and it established the field of economics.
It offered the reader a scathing criticism of mercantilism and made the case for
laissez-faire. Laissez-faire was a French term adopted by Smith to describe an
economic policy of limited government interference in markets.
When Smith began the study of economics, there was no division of
economics into microeconomics vs. macroeconomics. Smith and those who
followed him were primarily interested in policies that related to how markets
worked (microeconomics) and to in long term economic growth (microeconomics
and macroeconomics). Inquiry into business cycles (a part of macroeconomics)
largely developed as a sub-field of economics in the 19th century.

What was New about Smiths Approach?

Adam Smith was interested in explaining how people make economic
decisions in markets. Why did decision makers do what they did? What
motivated their decisions and what were the economic and social consequences
of their actions?

While this may seem very simple and basic, it was actually quite new at
the time. As noted above, pre-capitalist economies used markets sparingly and
references to economic issues were only scattered in among the writings of
scholars who were primarily concerned with ethics, politics, philosophy, or
theology.
In addition, these scattered discussions of economic issues found in the
writings of pre-capitalist scholars tended to deal entirely with economics from a
moral or ethical perspective. Most involved discussions of what people ought to
do, rather than what they actually did. Economists call this kind of ethics-oriented
discussion normative analysis. On the other hand, discussions about what
people actually do, and how the economy actually works, fall within the bounds of
positive analysis. It is fair to say that most (if not all) economic analysis before
the advent of market economies was normative.
For example, when it came to matters involving prices, pre-capitalist
scholars provided very little analysis of what actually determined market prices.
However, they got into heated discussion about what prices ought to be. In
Europe, these scholars usually argued that prices should be "just." In traditional
economies, prices were considered just when they served to maintain the correct
social order. Everyone, it was argued, had their correct place in society and
market transactions should not disrupt this order. When market prices were
unjust, they were too low or too high and people therefore fell or rose in rank as a
consequence. The doctrine of "Just Price" (and the numerous laws that it gave
rise to) were intended to protect society from unjust markets.
Profit and profit seeking were treated in similar fashion. St. Augustine, an
early leader of the Christian Church in Europe, condemned profit as sin because
making a profit was tantamount to theft. Augustine argued that profit was the
result of buying at one price and selling at another price. But, he reasoned, a
product could never have two different just prices. Consequently, the man who
earned a profit was a thief who had either paid too little for the product initially, or
had subsequently sold it too high. In the first case, he had stolen from the person
that he had bought it from; in the second case, he had stolen from his buyer. For
Augustine, the only interesting question about profit was the identity of the injured
party.
Notice that these discussions of prices and profits do not display any real
interest in explaining the process of price formation or the role of prices or profits
in economic activity. The analysis is normative, not positive, and served primarily
to restrict and condemn market transactions. This disapproval, or at least
distrust, of markets and merchants has been very common around the world in
pre-market societies. Merchants were usually relegated to the fringes of societies
or confined to lower social classes. For example, Aristotle argued that pirating
was a more honorable occupation than being a merchant. Similarly, in Japan,
merchants were at the bottom of the social order, one level above untouchables.
It was not until the thirteenth century that church scholars came to grips
with St. Augustine's condemnation of profits and market activity. The person

most responsible for exonerating profits and profit making was St. Thomas
Aquinas. Aquinas argued that profits were not necessarily sinful provided they
were not excessive and if the proceeds were put to a just purpose such as
supporting ones family, community, and church. (It is amazing how many
cathedrals can be financed from the offerings of merchants anxious about their
souls.) We will not go further into the details of this revolution in economic
thought. Suffice it to note here that Aquinas legitimized markets and profit
making, but he still offered little insight into how markets actually worked.
But European economies were developing through market activity and the
growing use of markets created a need to understand how markets actually
worked, not just how they ought to work. While not the first to wrestle with this
task, Adam Smiths Wealth of Nations was the most successful and firmly
grounded economics in positive analysis. To be sure, there was still plenty of
room for policy discussions and normative analysis, but following Smith, the
positive inquiry came first.
Smith dispensed with the normative-analysis-only perspective and boldly
proclaimed that people acted out of self-interest. People do things because they
figure that it is in their self-interest to undertake that action. Smith went on to
argue that markets channeled self-interest into actions that produced benefits for
society as a whole. Smith then returned to the normative issue and argued that
the pursuit of self interest was in fact good for society. Markets allowed people to
pursue their self-interest and channeled this selfish behavior into activities that
made society better off.

Positive vs. Normative Analysis

Economists continue to stress the difference between positive and
normative analysis and you need to be able to distinguish between the two.
Positive analysis attempts to analyze how the world works. Disputes in positive
analysis can (at least conceptually) be resolved by appeal to empirical evidence
(that is, the facts). "An increase in the supply of money will produce inflation" is a
positive statement. Proponents and critics may argue about the validity of the
point and appeal to the historical record and/or economic models to support their
views. However, the important point is that it should be (subject to data
limitations) possible to resolve this issue.
In contrast, normative analysis always introduces ethical and moral criteria
into the discussion. Normative analysis may appeal to positive theory, but it
always brings a standard of ethics, morality, or value judgments to the issue.
"Income is distributed unequally" is a positive statement. "Income should be
distributed more equally" is a normative statement. It introduces the notion of
good and bad. More equal is good; less equal is bad. All normative analysis is

10

readily identifiable by the use of such terms as "good," "bad," "should," "ought
to," "better," etc.
The critical point to note about the distinction between positive and
normative analysis is that good and bad are ethical terms, not economic terms.
There is nothing in economics that supports, defends, or rejects any ethical
position. Economists argue that people make rational decisions within their
ethical systems. It does not, and cannot, address the rationality or morality of
those beliefs.
There are some ethical propositions that have a rather large following and
are often assumed to be generally valid. For example, economists will often
proceed on the basis of a value judgment that more material goods is better than
less material goods. While most people have little trouble accepting this, there is
a counter perspective. If one believes that material possessions corrupt the soul,
then more material goods may lead one further from God. Therefore, less
material goods would be better than more material goods. Who is right? You will
have to decide this one for yourself - but the main point is that the battle must be
waged in the realm of religion, ethics, and value judgments, not economics.
Economic analysis cannot resolve this dispute and attempts to resolve any
normative question apart from its ethical underpinnings is doomed to failure.

Positive vs. Normative: A Ridiculous Example to make an Important Point

Consider the following statement: If you had an infinite amount of time
and an infinite number of monkeys working on an infinite number of typewriters
(yes, typewriters), one of them would eventually write Hamlet.
This is a ridiculous proposition and people who spend too much time on it
should make you nervous. However, lets consider this extreme proposition to
make a point: Positive statements are at least theoretically verifiable and they do
not involve value judgments. By this criterion, this is a positive statement. First,
there is no value judgment (no one is saying monkeys banging away on
typewriters are either good or bad). And if we could observe infinity, we could
probably resolve the question. Even though infinity is involved, this remains the
appropriate criteria for distinguishing between positive and normative statements.
(As for the actual monkey question at hand, I think it is rather absurd and unlikely
- I would expect something like: To be or not to pee .. Doh! monkey starts
over).

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The Economic Approach: Rational Choice

Adam Smith argued that people tend to look out for themselves. They
weigh the cost of doing something against the expected benefit and end up doing
things that bring more benefit than cost. Economists call this rational behavior.
By this, they mean that people weigh the benefits of an action (as they see them)
against the costs of an action (as they see them) and then act in a manner
consistent with their best interests. The critical juncture in the argument is the "as
they see them" part. "As they see them" means that benefits and costs are
subjective. In other words, there is no objective assessment of rationality.
Economists run into a lot of misinterpretation on this point. In other
disciplines, rationality usually means that one's perceptions of the world are valid.
In economics, rationality means that people take actions based on the world as
they see it. They may or may not be rational in the psychological sense, but they
are always rational in the economic sense. For example, if you actually thought
that you were Napoleon, psychiatrists would say that you were irrational.
However, economists would argue that you are still acting in a completely
rational manner when you kept looking over your shoulder, on guard against your
next encounter with the Duke of Wellington. (Recall that it was the Duke of
Wellington who defeated Napoleon at Waterloo, thus ending his comeback and
condemning him to exile on a rocky island in the middle of the Atlantic for the rest
of his life definitely a bummer.)
It is also important to note that rationality does not mean that people never
make mistakes. People make mistakes all the time. When they do, they usually
pay a price. At other times, dumb luck may intervene on their behalf. Rationality
explains the basis for a decision, not the wisdom of the undertaking or its
necessary outcome.

A Case Study in Error: Why was Columbus out in the Atlantic?

This last point can be illustrated by the case of Christopher Columbus.
Contrary to popular belief, Columbus was not the originator of the idea of sailing
west across the Atlantic to circumnavigate the globe in order to reach Asia. The
Garibaldi Brothers from Genoa had sailed out into the Atlantic with this goal in
the thirteenth century - unfortunately, they never came back.
In Columbuss day, virtually all educated people, and certainly all men with
sailing experience, knew that the world was round. What they were unsure of
was how far it was to Asia and how to keep from getting lost at sea with the very
rudimentary navigation techniques of their day.
In 1474, Paolo Toscanelli popularized the idea that the distance from
Europe to Asia was much smaller than had been previously thought. King
12

Manuel of Portugal sent out an expedition based on Toscanellis theory that

same year, but it failed to find Asia. The Portuguese soon concluded that
Toscanellis calculations were simply wrong. And most other European officials
and scholars involved with exploration had come to the same conclusion about
Toscanellis numbers.
However, some ten years later, Columbus came up with his own plan
based on Toscanellis calculations. He figured that he could reach Japan by
sailing west for 2,400 miles. He would then sail another 1,150 miles to reach
Hang Chou, China.
Columbus was wrong - the correct distances to Japan and China were
10,600 miles and 1,166 miles respectively. Since most advisors to European
governments were aware of Toscanellis error, Portugal, Spain, and England all
rejected Columbus plan as being infeasible due to his underestimation of the
distances involved. However, a fourth try at selling the idea to the Queen of
Spain proved successful and Columbus made his voyage in 1492.
It is important to point out that both Columbus and Queen Isabella were
wrong. However, they were rational, undertaking the voyage because the
benefits (as they perceived them) exceeded the costs (as they perceived them).
The mission also failed to attain its objective - Columbus never did find Asia and,
in fact, never even realized his error. But he was elevated to the rank of Admiral
of the Seas and richly rewarded. For Spain, the mistake led to the colonization of
the New World and to the discovery of vast quantities of gold and silver that
would finance a century and a half of Spanish empire-building.
In a fair and just world, people who make terrible mistakes are not
rewarded - but this is not always a fair and just world. The voyages of Columbus
are a case in point; despite making a huge error, Columbus and Spain both
prospered from their mistake. (Perhaps the holiday on October 12 ought to be renamed or at least subtitled: Fools-Sometimes-Get-Lucky Day.) But whether
Columbus got his just reward is not the point; the important point is that
Columbus decision was rational because it was predicated on his weighing of
the costs and the benefits. In that weighing, he was rational - and wrong.

The Nature of Costs and Benefits

The topic of costs and benefits will come up often in this course. A few
words about these terms are in order here.
Benefits are something positive that accrue as the result of a decision.
Costs are something lost or given up as a result of a decision. Economists argue
that the basis for all cost is lost opportunity. Lost opportunity means that
something is given up, lost, or foregone as a direct consequence of undertaking
an action. In the economic discussion of costs and benefits, the emphasis is on
decision making and it is forward looking. In many respects, accounting is the

13

opposite of economics. In economics, one is interested in how anticipated

benefits and costs relate to actions undertaken; in accounting, one tracks past
performance; that is, one accounts for what has happened. Accounting is
inherently backward looking (backward looking, not backward). This is not a
matter of which discipline is doing it right; it is instead a question of what one
wants to do.
In economics, benefits and opportunity costs are:
1.

Subjective

2.

Both explicit and implicit

3.

Ex Ante, rather than ex post

4. Based on an honest assessment of the value of the next-best

alternative foregone (This applies to costs only, not benefits.)
5.

Relevant

We will briefly look at each of these in turn.

Economic Benefits and Costs are Subjective

Point #1 says that the actual weighing of costs and benefits is always up to
the individual decision-maker. What matters is how that person subjectively sees
it. Another way of saying this is to say that there is no objective, external criteria
that determines what is or is not an opportunity cost. Outside observers can
understand and estimate subjective costs incurred by decision-makers by trying
to see the world as the decision maker sees it. But one must always keep the
perspective of the decision-maker, not the outside observer.

Economic Benefits and Costs are both Explicit and Implicit

Point #2 says that financial costs are part of opportunity costs (explicit),
but so are non-financial costs (implicit). These implicit costs include waiting
costs, time costs, aggravation costs, foreclosed-option costs, and costs that stem
from exposure to the risk of injury or loss. For example, lost sleep could be a
cost of attending early morning classes.

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Economic analysis, with its assumption of rationality and benefit/cost

comparisons, has often given people the mistaken impression that only material
benefits and costs are weighed. What about ethics and morality? What about
unselfish acts of kindness and charity?
There is nothing in economic analysis that precludes decision-makers
from valuing love, peace, virtue, honesty, and charity (or counting the loss of any
of these as a cost). For many, acting in a moral fashion has great value and it
would be impossible to understand their actions without appreciating how these
factors influence their weighing of costs and benefits.

Economic Benefits and Costs must be evaluated Ex Ante

Point #3 says that costs (and benefits) must be evaluated ex ante, not ex
post. This simply means that you weigh the consequences of a decision before
you know the outcome. Ex ante means before the fact, while ex post means
after the fact. The need for ex ante rather than ex post weighing of costs and
benefits in decision-making can be illustrated with one of Will Roger's famous
quotes. Will Rogers (1879-1935) was one of the first American comedians and
political commentators to gain a national following. Rogers once told his
audience that making money in the stock market was easy: All one had to do
was to buy stocks low and then sell them when they went up. And if they dont go
up, then you dont buy them! Whether an audience today would find this funny is
debatable, but the joke was based on a deliberate confusing of ex post with ex
ante.
Exposure to the possibility of injury or loss is also an implicit cost. This
cost is called risk, and it is an opportunity cost provided that it is considered ex
ante. In other words, your decision to fly or not to fly on an airline probably
weighed the risk involved. You probably looked at this as a matter of probability.
Of course, the issue would not arise if you knew the plane was going to crash (or
not crash). You would never fly if you knew that the plane was going to crash (or
at least we hope not) and you would not hesitate to fly if you knew it was not
going to crash. But that is the point - risk is an ex ante opportunity cost. If an
airplane does crash, accountants will have to deal with the ex post costs. But
accountants are not decision makers and they deal with loss, not risk. This
distinction lies at the heart of the distinction between ex ante and ex post.
When assessing risk, it is important to keep in mind that decision-makers
often use subjective criteria. For example, Lotto players usually use very
subjective probabilities in deciding to play. In other words, they pay little attention
to the mathematical probabilities, preferring instead to concentrate on their own
view of the odds (and joy) of winning. For example, you have a greater statistical
likelihood of being struck by lightening than winning the Lotto, yet Lotto players
do play and they seldom concern themselves about thunderstorms.

15

It is always important to understand the distinction between subjective

versus objective probabilities in decision making. All casinos profit from huge
discrepancies between true odds and subjective odds. As a case in point,
consider Keno, a game usually played by the bored and/or the criminally stupid.
Despite the dismal true odds, Keno players feel confident of their chances.
Worse, discussions of the true odds usually do little to dissuade people with
strong subjective views of the likelihood of outcomes. The point here is that the
subjective probabilities, even when grossly wrong, are relevant in decision
making.
The importance of the distinction between true odds and subjective odds
can also be seen in the air travel industry. Fear of flying is a real concern among
some and this impacts the demand for air travel, especially following an air
disaster. Yet all of the statistics confirm that flying is the safest means of travel.
The mathematical probability of dying on your next airline flight is one in seven
million. (Notice that the odds of winning the jackpot in the California Lotto are
closer to one in 45 million.) To put this in further perspective, a person flying
everyday can expect to die every 19,000 years. While shorter commuter flights
are three to four times as dangerous as flights on major airlines, a person
actually faces a far greater chance of dying of a heart attack while waiting for his
bags at the luggage carousel than of dying on one of these dangerous flights.
The gap between objective probabilities versus subjective probabilities
can be large and important. No airline can ignore perceptions of air safety and
lotteries only work because of greatly exaggerated subjective probabilities.
Decision-making is clearly dependent on subjective perspective.

Economic Cost is an Opportunity Cost

Point #4 says that lost opportunity must be measured as the value of what
is actually foregone in the next-best alternative. Obviously, this must be based on
an ex ante consideration. For example, if you go to class instead of going to the
race track to bet on the horses, you lose the opportunity to bet on races (but
before you know who wins). It is the probability of winning (and losing) that is
foregone. One should also note that this is a legitimate opportunity cost only if
you would have actually gone to the horse track if you had not been in class. On
the other hand, if you would have been sitting with your friends in the cafeteria
instead of going to class, then that would be your next best alternative. Note that
evaluating lost opportunity gives you a wonderful chance to lie to yourself - if I
dont go to class, then I would be writing a best selling novel. This is only true if it
is actually your next-best alternative activity.

16

Economic Benefits and Costs are Relevant Benefits and Cost

Point #5 requires that all costs and benefits must be relevant. In
economics, we define relevant costs and relevant benefits as costs and benefits
that will be impacted by a decision. On the other hand, irrelevant costs and
irrelevant benefits are costs and benefits that will not be impacted by a decision.
The most important point here is to distinguish between sunken benefits and
costs versus incremental or marginal benefits and costs. In decision making,
sunken costs are usually irrelevant because they are not affected by the
decision. For example, if you are thinking about dropping a class late in the
quarter, your tuition fees become irrelevant because tuition fees will not be
returned regardless of whether you drop or stay.
Incremental essentially means additional and the term marginal should
always be translated as the impact of one more or one less. At this point, we will
treat the two as virtually synonymous. Most importantly, marginal or incremental
costs and benefits are usually relevant costs in decision making because they
quantify the additional benefits and costs that result from a decision.

One Final Point: The Choice Field

An additional point about rationality and weighing costs against benefits is
in order. While economists feel comfortable about explaining how choices stem
from the subjective assessment of relevant costs and benefits, they cannot
explain which options people are willing or unwilling to put in the choice field in
the first place. What are you willing to do? For example, if you were not a
student, would you be a drug dealer? (If you are a dealer, you may skip the next
question.) Are you not currently dealing in cocaine simply because you are
afraid of getting caught? If so, you have made a benefit/cost comparison. On the
other hand, you might find the idea of dealing in drugs to be morally
unacceptable and not a relevant choice consideration. This removes the option
from the choice field and your decision is not based on a benefit/cost
comparison.
Or consider another example: Have you ever considered cannibalism as
an alternative to the high cost of beef? (This is a rhetorical question, not an
invitation to confess.) For most, this choice option is unacceptable and not
subject to benefit/cost evaluation. In any case, the decision to include cannibal
dishes on the menu is a moral and ethical determination, not an economic
choice.
To illustrate this point with a more serious example, consider the question
of slavery in the American South before the Civil War. Why did slavery become
17

entrenched in the southern English colonies? At different times, slavery has been
practiced all around the world. However, while England had a long feudal history,
slavery was almost unknown in recent times. It is commonly argued that southern
plantation owners (or soon-to-be plantation owners) resorted to slavery in order
to overcome a severe labor shortage. There is some truth in this claim; the
benefits and costs of slave labor were weighed and slavery was adopted. But
one must be careful to keep the issues separate. In weighing the costs versus
the benefits of slavery, Southerners were rational, but this is not an excuse or
even an adequate explanation. The real question is why was slavery considered
in the first place? That is not an economic question - it is an ethical matter.

Mini Cases and Applications

The remainder of this chapter is devoted to mini cases and examples
where the economic approach developed above is applied to specific situations.
A Case of Lost Opportunity: Normal Profit as a Cost
There are many differences in how economists and accountants treat
costs. Perhaps the biggest difference can be found in the willingness of
economists to treat a normal accounting rate of return as an opportunity cost.
In accounting, costs are restricted to explicit costs compiled according to
rules acceptable to the accounting profession and tax authorities. Implicit and
subjective costs have no place in the business of accounting. This is as it should
be; the different treatment of costs by economists is not a criticism of accounting
it is simply a look at costs from a different perspective, i.e., from a decisionmaking perspective.
Economists argue that a normal accounting profit is a relevant and
necessary cost of production. Normal profit is the income that the firm could be
earning in its next-best alternative and is therefore a relevant opportunity cost to
the firm.
This is in danger of becoming a bit abstract, so lets make the point a
different way. Both accountants and economists agree that wages are a cost of
production. Workers must be paid. If wages are not paid, workers stop working.
Economists argue that a normal profit is no different. If a firm cannot earn at least
a normal profit in an activity, it stops that activity and pursues its next-best
alternative. Unlike wages, normal profits are not an explicit cost, however, they
still need to be earned (and paid to the owners) if production is to continue.
Resource holders simply will not continue to keep resources committed to
activities that they feel will not give them a return that is readily available
elsewhere.

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In all of the discussion of costs that follow in this course, we will assume
that a normal profit is an opportunity cost that is always a part of rational decision
making.

An Application of Relevant Costs and Benefits: To Call or Fold in Poker

Suppose that you are playing Texas Holdem poker and you are on the
last round of betting (on the river if you play). Two other players have raised and
you must decide whether to call (i.e., match) the raise or drop out of the hand (we
will assume you are not going to raise). The bet is $1,000, but you have already
put $5,000 of your money into the pot. What are the relevant costs and benefits
of calling?
The relevant cost is the incremental or marginal cost, that is, $1,000. The
$5,000 that you have already put in the game is a sunken cost and is therefore
irrelevant. This is not a relevant cost because there is no decision that you can
make that will affect the $5,000 already committed. (Note: dont try to just reach
in and take your money out it is amazing how upset people will get.) Note that
the size of the pot (including your contribution) is a relevant benefit that must be
factored into your decision. Your decision requires that you weigh the relevant
cost (i.e., $1,000) against the probability of winning the entire pot.
This example also illustrates a significant difference between business
and economics. In economics, we can easily frame the issue, but success in
business often rests on the art of application, that is, the key to business success
is to be able to act and apply concepts in a very chaotic and uncertain world.
Likewise, a big part of success poker stems from your ability to think logically in a
very stressful situation you have to get your brain to ignore the $5,000 while
your gut is screaming that its your money in there!

An Example of Relevant versus Irrelevant Costs: On the Perils of Getting it

Wrong
In the early 1970s, Franklin National Bank, with headquarters in Franklin
Square, New York, was the nations 20th largest bank and was doing a robust
loan business. Customers were lined up for loans because the bank was
charging interest rates well below the rates offered by its competitors. Life was
good at Franklin; there is nothing like a long line of customers to make the suits
happy. However, on October 8, 1974, Franklin Bank became the nations largest
bank failure in history to date and was taken over by the Federal Deposit
Insurance Corporation. What went wrong?

19

There are quite a few things that one could say about Franklin National.
On the positive side, the bank was a pioneer in developing the drive-up teller
window in 1950; it was an early issuer of bank credit cards in 1951; it was one of
the first banks to initiate a no-smoking policy in 1958; and it was a pioneer in
introducing outdoor teller machines at its branch banks in 1968. On the negative
side, there were persistent rumors linking the bank with the Mafia. However,
none of these allegations had much to do with the collapse; the demise of the
bank can be traced to a fundamental mistake in its lending policies.
Franklins lending strategy was simple: offer interest rates to borrowers
that were at least 1 percent above the average cost of the banks funds. It is hard
to see why a bank that charges more to lenders than it pays to its depositors and
creditors can go wrong, but a closer examination reveals the crucial error.
Like most banks at the time, Franklin got its money from four sources: 1)
invested capital; 2) demand deposits (that is, checking accounts) in the bank; 3)
savings deposits in the bank; and 4) funds borrowed in the federal funds market.
The first, capital invested, was rather small and often had to be retained to satisfy
reserve and capital requirements. The bulk of the funds for lending therefore
came from the other three sources.
In 1974, Franklin had demand deposits of about $2 billion and these
accounts cost the bank about 2.25%. Franklins savings accounts in 1974 totaled
about $1 billion dollars and cost the bank about 4% annually. Both of these
deposit sources were relatively low-cost sources of funds, but they were rather
inflexible. The banks deposits were already invested and additional funds from
these sources were limited to the growth of deposits.
The fourth source of funding was the federal funds market. This was a
market where banks lent and borrowed money on a very short term basis. The
federal funds market got its name from the practice of banks lending out their
excess funds (i.e., funds above their federal reserve requirements) to banks that
needed borrowed funds to meet their federal reserve requirements. Unlike
savings and checking deposits, federal funds market money was usually readily
available, but at much higher interest rates. In 1973 and 1974, Franklin Bank was
paying between 6% and 11% for these funds. In 1974, Franklin had acquired
about $1.7 billion from the federal funds market at these higher interest rates. On
average, these funds cost the bank about 10% during this period.
Using these figures, we can compute Franklins weighted average cost of
funds in 1974:
The weighted average cost of funds was:
$2 billion @ 2.25% + $1 billion @ 4% + $1.7 billion @ 10%

= 5.42%

$4.7 billion

20

On average, funds cost the bank 5.42%. Franklin then lent these funds out
at an average interest rate of about 6.5%. Other banks were generally charging
more than 10% to loan customers - no wonder customers were lined up for loans
at Franklin.
The problem with this strategy can be seen in the equation above. While
the average cost of funds was 5.42%, this rate only covered the funds obtained
from deposits. But all new loans had to be funded with money acquired in the
federal funds market. The interest rate for these funds was 10%, well above the
rate that the bank was charging its borrowers. Franklin was losing money on all
of these loans. Worse, while it was losing money, bank executives were happy
because they thought they were making money. (There is nothing worse than
being stupid with a dumb grin on your face.)
The banks error can be described in the terms introduced earlier in this
chapter: Franklin Bank was losing money because it did not recognize that the
relevant cost of funds was the marginal cost, not the average cost. In economics
and business, marginal always means the next one, or the last one, or the
incremental one, etc. In decision making (e.g., the decision to make a loan) the
relevant cost is usually the marginal or incremental cost.
In the case of Franklin, the next loan was going to be funded with money
from the federal funds market that cost about 10%. This was the marginal cost of
funds and the marginal cost of funds should have been the relevant cost for the
banks lending decisions. The average cost of bank funds (5.42%) was irrelevant
because the next loan was not going to be funded with deposit funds. Franklin
would have been on sound footing if it had lent money at interest rates 1% above
its marginal cost of funds rather than its average costs. When Franklin borrowed
money at 10% in order to fund a loan made to a customer at a 6.5% interest rate,
the bank lost money. More than a third of the banks loans were made where the
marginal cost of funds exceeded the interest rates charged to the banks
customers. You cannot make money this way. In addition, every loan made
under these terms further weakened the bank.
In the real world, there is no big neon sign that lights-up to announce that
you have made a mistake and are about to pay for it. Instead, when a problem
arises, you are usually drained trying to figure out what is wrong. Unfortunately,
Franklin never did figure it out. They were making loans, but not money, and
could not figure out why.
In addition, as the bank grew weaker and weaker, management became
ever more desperate. As a consequence, the bank began to pursue greater
returns, but only at the cost of assuming greater risks. Franklin began to
speculate in risky foreign exchange markets. When these positions turned sour,
the bank went into bankruptcy. However, while the risky investments in the
foreign exchange market were the immediate cause of the banks demise, the
real cause was the banks fatal error in not understanding that it was marginal
costs - not average costs - that were relevant. (In an interesting parallel, the
investment banks that failed in 2008 Bear Sterns, Lehman Brothers, and Merrill

21

Lynch all seem to have resorted to similar speculative Hail Mary strategies
just prior to their demise. But in these cases as well, the final desperate
speculation was more consequence than cause.)
In the discussion of Columbus, we noted that some mistakes do in fact
pay off Columbus and Isabel never got nailed for screwing up. In the case of
Franklin, we return to the norm the mistake ended up bankrupting the bank.
One can only hope that the six-figure executives who made the mistake received
their fair share of pain and suffering.
While we have emphasized that average cost were not relevant to
Franklins business model, it should be pointed out that its average cost were
perfectly relevant to another question, that is, the accounting question. To
determine profits, one could look at the average cost of funds and then at the
interest rates charged in order to determine a profit margin. This could then be
multiplied by the amount of funds lent in order to calculate total profits.
This calculation would be relevant for accounting purposes, but it is
definitely not relevant for determining how much to charge for your next loan. In
decision-making, marginal costs are usually the only costs that matter.
[Source note: Some data cited above was obtained from: Robert Thomas, Microeconomic
Applications: Understanding the American Economy (Belmont, CA: Wadsworth, 1981): 87-91.]

An Example of Implicit Benefits: Biore Strips

Biore Strips are used to remove blackheads from the skin on the nose.
You moisten a plastic strip coated with an adhesive, apply, wait, and then
remove. The strip pulls away all of those blackheads that have been clogging
your pores.
What are the benefits and costs that explain why this product sells well (let
alone why it exists in the first place)? To understand the success of the product,
one must understand how implicit benefits are just as important as explicit
benefits.
As for costs, the price that you pay for Biore Strips pretty much captures
all of the relevant costs. But what about the benefits? Clean nose skin is certainly
the primary explicit benefit, but this is still a very limited benefit since the product
cannot be used anywhere else on the face. If you think about it, a clean nose on
a dirty face is not all that great.
Arguably, a good loofa sponge or face scrubber might be more effective,
but neither has the unique benefit of the Biore strip. The real benefit of the strip is
an implicit benefit that is deeply rooted in human nature. What do you do when
you take the strip off? (Those who have used the product know; those who
havent used it will have to figure it out or guess). Answer: You look at it. There is

22

something quite appealing to seeing what just came out of those dirty pores. In
fact, if your friends are around, what will you do? That is right, you will show them
this is too good not to be shared. This is an implicit, subjective benefit that is at
the heart of the companys business model (I assure you, there is someone at
Biore right now who is working on how to promote strip-viewing parties or some
such devises).
Now that we have taken care of hygiene, lets consider a case where a
failure to distinguish relevant from irrelevant costs led to some unwarranted
criticism.

Application: Did NASA really deserve another one of Those Awards?

The Hubble Telescope was launched into orbit in 1990. Unfortunately, just
after the launch, scientists discovered that the Hubble Telescope had a problem.
There had been a mistake in grinding the telescopes mirror that left the
telescope unable to focus correctly. In essence, the telescope was nearsighted.
Now a nearsighted telescope is truly a sad thing to behold and scientists devised
a correction for the error (sort of like fitting it with corrective glasses). However,
the fix had to be made in space and the scientists turned to NASA (the National
Atmospheric and Space Administration) to use the space shuttle for a mission to
fix the Hubble Telescope.
NASA agreed to charge the Hubble Project $378 million for the use of the
space shuttle to fix the telescope. The Hubble Project agreed to the price and, in
1993, the mission was undertaken and the telescope fixed.
This might have been the happy ending to the story of the little telescope
that needed glasses were it not for critics who quickly complained that NASA had
grossly wasted taxpayer money on the Hubble launch. The critics wanted to
know: Where were the Golden Fleece Awards when you needed them most?
Golden Fleece Awards had been awarded by Sen. William Proxmire (DWis) from 1975 through 1988. Sen. Proxmire had gained a reputation as a
crusader against waste in government and had hit upon the award as a clever
gimmick to shame wasteful government agencies; he awarded Golden Fleece
Awards to government agencies with the most egregious waste. He got the idea
from Laugh In, a 1960s television show that awarded Flying Fickle Finger of Fate
Awards to people or organizations that screwed up.
Some of Proxmires more memorable Golden Fleece Awards went to:

the National Science Foundation for spending $84,000 on a study of

why people fall in love

23

the Justice Department for conducting a study on why prisoners

wanted to get out of jail

the National Institute of Mental Health for funding a study of a Peruvian

brothel. (The project reportedly paid for numerous trips to brothels to
gather data.)

the Federal Aviation Agency (FAA) for funding a studying of the

physical measurements of 432 airline stewardesses, with special
attention paid to the length of the buttocks

NASA in 1978 for funding the Search for Extra-Terrestrial Intelligence

Project (SETI Project) to look for intelligent life in other worlds. Sen.
Proxmire followed up the award with efforts to kill funding for SETI in
1981, but his efforts failed.

While many award recipients certainly deserved the ridicule, Sen.

Proxmire was sometimes accused of lambasting projects that had led to
important findings or breakthroughs. The Senator did in fact later apologize for a
few of the awards, including the award that he had given to NASA for its SETI
Project. But in most cases, a Golden Fleece Award stuck and the award was
credited with killing some of the worst pork barrel projects.
When Sen. Proxmire left the Senate in 1989, the awards stopped. But
NASAs critics demanded that the awards be revived with NASA as its first new
recipient. The critics argued that NASA had only charged $378 million for the use
of the space shuttle, a figure that was a mere fraction of the cost of the launch.
The critics pointed out that the Space Shuttle Program at NASA had an annual
budget of $4.6 billion and was averaging four launches per year. Simple division
put the average cost of a space shuttle launch at $1.15 billion. What kind of fools
at NASA charged $378 million for a space shuttle launch that cost $1.15 billion?
NASA responded by pointing out that while its budget was $4.6 billion per
year, $4 billion of this was for fixed costs. If a shuttle mission was not
undertaken, NASA could avoid $44 million in launch and mission costs.
Based on this information, there are number of interesting questions in this
case:
1. Was the $1.15 billion the relevant accounting cost per flight?
2. Was the $1.15 billion the relevant economic cost per flight?
3. What was the incremental economic profit or loss to NASA of the
Hubble launch?

24

4. Were the critics correct in calling for a Golden Fleece Award for
NASA? Why or why not?
5. When would the $4.6 billion annual Space Shuttle budget be a
relevant economic cost?
6. Suppose that a space shuttle launch had already been scheduled
and was going to take place regardless of whether the Hubble fix
was aboard. What would be the relevant shuttle cost in the decision
to accept (and price) the Hubble launch?
7. Suppose the scenario in # 6 above applies except that undertaking
the Hubble project on this flight would require not undertaking
another science project that NASA was charging $35 million for?
What would the relevant economic costs be of undertaking the
Hubble project on this launch?
8. Note that the critics never raised the issue as to whether the
Hubble project might have been willing (or forced) to pay more than
$378 million because NASA was the only space launch available
(that is, there was no other game in town). Might this have been a
relevant opportunity cost and a legitimate criticism?

Application: Why do Airlines Discount Tickets?

Airlines have substantial costs. Their planes are expensive, they are
expensive to maintain, their business operations require a large skilled
workforce, and the airlines consume enormous quantities of fuel.
When a scheduled airline (that is, an airline that has a scheduled flight, as
opposed to a charter operation) has unsold seats, it will often discount tickets in
order to fill these empty seats. The discounts are often substantial; discounted
tickets often sell for a small fraction of the full-fare ticket price. Why do the
airlines offer such huge discounts when they have such large costs to contend
with? We will use the concepts of relevant costs and incremental costs to explain
the airlines discounting policies.
First, if we were talking about accounting for airline operations (that is,
doing the books) all of the costs described above would be relevant. They are
relevant accounting costs because they are all legitimate costs that must be
accounted for.
However, this is not the case when we are talking about the airlines
decision to offer steep discounts. For this question, most airline costs are
irrelevant because they are sunken costs. From a decision-making perspective,
sunken costs are usually irrelevant.

25

For example, while an airline flight will consume a lot of fuel and incur a
rather hefty fuel bill, the only relevant part of this cost to the discounting issue is
the incremental fuel cost. The incremental fuel cost is the extra fuel needed to
carry an additional passenger in that empty seat. How much do you think that is?
You are correct - it is next to nothing. In other words, the accounting fuel costs
are very high, but the relevant incremental costs are very low.
What about the flight crew costs? The airlines have to pay for a pilot and a
co-pilot (and perhaps a third navigator on some flights). This is a substantial
labor cost. However, while it is relevant to accounting, it is completely irrelevant
to the discounting decision because the crew is going (and going to be paid)
regardless of whether there is a passenger sitting in a seat.
Cabin personnel costs (that is flight attendants, etc.) are similar. Most
flight attendant costs are sunken and therefore irrelevant (the flight attendants
are going anyway, regardless of the number of passengers). The only relevant
incremental flight attendant costs would be the costs associated with bringing
another flight attendant in to handle a very booked flight (in other words, if the
discounting is very successful in filling the plane).
What about relevant food costs? The additional cost of an in-flight meal
and beverage would be a relevant incremental cost. How much is that? If you
have eaten airplane food, you know it isnt much. (On Southwest Airlines,
incremental food costs are a soft drink and a bag of peanuts two bags if you
are lucky.)
And what about landing fees? Most landing fees are based on the type of
plane. In this case, there are no relevant incremental landing fees. If landing fees
are based on passenger count, then the incremental landing fee cost is the extra
fees due because the seat is occupied.
The same analysis applies to the other costs associated with discounting
tickets: incremental risk costs, incremental baggage handling costs, incremental
overhead and administration costs, etc. are all ridiculously small. Is it any wonder
that airlines can offer such step discounts when the relevant costs are so low? Of
course not.
About fifteen years ago, I had a student in this class who worked for
American Airlines. At the time, the CEO of American Airlines had announced that
American was going to stop the practice of discounting. I offered that it was not
going to happen because the benefit/cost scenario overwhelmingly favored
discounting; she insisted that the company was serious about ending the
practice. After great fanfare, Americans no-discounting policy was quietly
abandoned.
This description of the relevant costs of ticket discounting is incomplete. In
fact, we have not brought up the only significant cost of discounting lost full-fare
ticket sales. This is an opportunity cost that is measured by the lost revenue that
occurs when a customer who would have otherwise paid full-fare manages to
purchase a discounted ticket instead.

26

Airlines recognize that this is virtually the only significant cost of

discounting and they take extra precautions to minimize this cost. We will look at
what the airlines do to minimize this cost later when we look at price
discrimination in the airline industry.

An Example of Relevant Costs: Acquisition Costs

What does it cost you to acquire a commodity, a product, or an asset? In
accounting, the cost of acquiring an item would be the purchase price. While one
can bring in additional dimensions to this accounting question (e.g., buying in
installments, multi-period analysis, financing, etc.) the basic proposition holds the cost of acquiring something is measured by the price that is paid for it.
For accounting purposes, this is the correct relevant cost. However,
economics is more concerned with decision making than with accounting and
uses the concept of actual lost opportunity for a different take on acquisition cost.
The relevant economic cost of acquiring is limited to the actual lost opportunity
arising from the decision to purchase. For this purpose, the price paid is simply
not a good measure of lost opportunity.
Instead, economists offer the following as a better measure of the relevant
economic costs of acquiring a product or asset:
Acquisition cost = Purchase price - Immediate resale value
The rationale here is that the decision to buy only commits the buyer to
that part of an expenditure that is irrevocably lost. We will define irrevocably lost
as that part of the expended funds that cannot be immediately recovered by
resale. In the extreme, if you could immediately resell at full-price (or return for a
full refund), there would be zero acquisition cost. At the other extreme, the
purchase price of the product would be the acquisition cost only if there was no
opportunity of re-selling (or returning for refund).
Again, this is not an accounting-versus-economics issue; it is a matter of
choosing the relevant cost. In accounting, purchase price is relevant; in
economics, the acquisition cost formula above is relevant.
The economic concept of acquisition cost is often encountered in the real
world. For example, suppose that you buy a new car and drive it off the
showroom floor. What is the acquisition cost? Any car that leaves the showroom
immediately becomes a used car and will have lost value. In economics, this loss
in value is the relevant acquisition cost.
This distinction has also served as the basis for advertising strategies. Car
makers such as Mercedes Benz and BMW have, over the years, tried to use this
distinction to make the case that while their cars have high prices, they have
27

lower acquisition costs. These firms have had advertising campaigns that point
out that their cars retain their value very well, thus reducing their acquisition
costs.
If you shop at stores with liberal return policies, you are probably already
aware of the point that economists are trying to make here. Exchange and refund
policies certainly impact acquisition costs, but customers need to pay particular
attention to how a refund or return or buy-back guarantee is worded. For
example, a number of years ago, the Avis Car Rental Company was selling its
surplus car rentals as used cars with a full-price buy back guarantee. A buyer
could buy an Avis car and then return it within three days for a full-price buy
back. However, note that a guaranteed full-price buy-back is very different from a
full-refund return. With a refund, sales tax is returned to the buyer. However, a
buy-back constitutes a separate transaction in which the purchase price is
returned, but the sales taxes paid are not refunded.
Avis chose to do a buy-back rather than a refund. Why? The answer is:
making the guarantee a buy-back rather than a refund significantly raised the
acquisition cost and reduced the number of returns. Avis could advertise a
money-back guarantee while simultaneously minimizing the number of
customers who might actually return their vehicles. Of course, this strategy was
clearly predicated on the assumption that buyers would not understand the
distinction up front.
The economic definition of acquisition costs can also be used to explain
how goods with identical prices can have very different acquisition costs. For
example, products that are special ordered are likely to have higher acquisition
costs compared to in-stock products with the same price. The difference stems
from the likely re-sale scenario. Estimating an immediate re-sale value for special
order products requires that you consider the likelihood of connecting with two
very different types of buyers: a) connecting with a buyer who, like you, is
interested in the special features, or b) connecting with one of the more
numerous buyers that is more interested in the non-customized product. Since
you are anticipating the future, your determination is both subjective and risky. In
this case, the acquisition cost of a special-order product would be:

Acquisition cost Spec = Purchase price - [(P gen buyer ) (general re-sale value)
+ (P special buyer ) (special buyer re-sale value)]
In the formula above, P represents the probability of connecting with
each type of buyer (i.e., a special buyer or a general buyer).
As an example, consider the acquisition cost of ordering a black wedding
dress. We wont ask why you want one - our task is to only note the difference in
acquisition costs. First, lets agree that you are not going to be able to return this
dress to a traditional bridal store. (It might be a different story if you bought it at
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Goths-R-Us Bridal Boutique, but lets not go there.) To estimate the immediate
re-sale value, you would need to determine the different types of buyers who
might be interested in buying a black wedding dress. In addition, you would need
to estimate prices that each group might be willing to pay as well as the
probability of finding different types of buyers.
I can think of three types of buyers: a) people who want a black wedding
dress; b) people who would not be caught dead in a black wedding dress, and; c)
people who might buy the dress to go to a funeral.
The first group would probably be very excited about the dress and would
be willing to pay quite a bit for it. However, I suspect that the probability of finding
such a person is very low. The second group is very numerous and the
probability of finding one of these buyers is very high, however, they will probably
pay next to nothing for it. As for the third group, I suspect that they are not very
numerous and that they would not pay very much for the dress. (Funerals are not
really fashion events and a black wedding dress might be over-dressing.)
I do not have actual probabilities or re-sale values, but I would confidently
estimate that the combined resale value would be quite low and the acquisition
cost correspondingly high.

An Application of Acquisition Cost: Capital Specificity and Barriers to Entry

Barriers to entry are factors that shield the firm from new firms entering
industry and taking business from them. You have probably encountered this
term before and you will certainly see it featured in subsequent discussions. For
example, in Chapter 8, we will highlight the role of barriers to entry in our
discussion of market structures. In Chapter 9, we will devote a full chapter to
describing common sources of barriers to entry.
For now, lets link the concept of acquisition cost to a common barrier to
entry large capital costs that must be incurred by firms seeking to enter an
industry. There is no such thing as costless entry into a new industry, so the
concept of large or heavy capital costs as a barrier to entry is obviously a matter
of degree.
It is also easy to see that the mere size of the capital requirement (i.e., a
large dollar cost) may be sufficient to deter newcomers. However, the mere size
of the capital requirement may not be as significant as the capital specificity of
the investment. The concept of acquisition costs can illustrate this important
distinction.
Capital specificity refers to the easy with which capital assets can be used
for alternative purposes. When other uses are limited, we refer to these assets as
being specific assets. When alternative uses are readily available, we refer to

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these assets as non-specific assets. Obviously, asset specificity runs the full
spectrum from highly specific assets to completely general or non-specific.
Why would assets be specific? We can identify the following factors
affecting the degree to which assets might be specific to a particular deployment:

Assets may be task specific Specialized equipment is often more

productive than general-purpose equipment because it is specifically
tailored or calibrated for a narrow task, However, this specialization often
reduces its productivity when employed for purposes for which it was not
specifically designed.

Assets may be dedicated Facilities may be created to serve a specific

use or a specific customer in an area where there are no other customers
or activities. This might be viewed as an especially extreme version of task
specificity.

Assets may be location specific A facility built to serve a specific site

might dramatically reduce transportation costs, particularly if the site is not
adequately served by general transportation networks. However, this
scenario means that the relatively remote location of the facility diminishes
its use for other activities that are not close by.

Assets may be worker specific We usually think of machinery when we

consider assets and capital, but the term human capital should be a
reminder that workers and worker skills can be viewed assets as well.
When worker skills are specific to a particular task or location, the firms
commitment to employing those workers tends to create asset specificity.
The more unique and specialized the worker skills, the greater the
specificity is likely to be.

Specific versus non-specific assets can be illustrated with an example:

Suppose you needed to purchase a fleet of delivery trucks in order to enter an
industry. The trucks were more or less standard delivery trucks suitable to most
delivery purposes. We would refer to these trucks as limited-specificity capital.
That being the case, you would expect to pay less for general purpose trucks
than for specialty trucks. Equally important, should things go wrong and the
venture fail, your resale prices on non-specialized trucks would likely be much
higher than for specialized trucks. In fact, if we leave trucks aside and go to very
specialized capital equipment specifically created for the task at hand, the resale
price may be little more than the scrape price.

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To illustrate how this affects the size of the capital requirement and
therefore the size of the barrier to entry, consider the following extreme example:
Suppose one industry requires a capital commitment of $5 million while a second
industry requires a capital commitment of only $3 million. It looks like the first
industry might have the higher barriers to entry because the capital requirement
to enter is 67% higher. However, the relevant cost ought t be the acquisition cost
rather that prices of the capital because acquisition costs are better measures of
what the new entrants actually are risking in their attempt to enter. Suppose the
first industry with the $5 million capital costs entails investments that are very
non-specific. Suppose that immediate re-sale could recover 80% of the initial
cost. This means that entrants into the first entry would be committing to a
potential loss of $1 million (i.e., $5 million - $4 million).
Suppose the second industry with the $3 million capital requirement must
be spent on highly specific investments. In this case, resale is restricted and the
firm can only expect to recover 30% of its initial investment on resale. In this
case, the firms acquisition cost will be $2.1 million (i.e., $3 million - $900,000).
While capital requirements for an entering firm are much lower in the
second industry, highly-specific capital actually creates a much higher acquisition
costs and therefore a greater barrier to entry. Indeed, capital specificity is quite
often more important than the size of the capital requirement in creating a barrier
to entry.

Application: Business Models and Relevant Benefits - Broadcast TV versus

HBO
In decision making, relevant costs and benefits are confined to actual
costs and benefits that accrue as the result of a decision. Business organization
and institutions often determine these relevant costs and benefits. For example,
consider how the costs and benefits that accrue to HBO differ from those that
accrue to broadcast television broadcasters.
HBO provides television content to cable and satellite TV providers. Its
business model is very different from traditional television broadcasters and
production companies. Most broadcast television networks and stations make
money by selling advertisement. Content providers create shows that these
television stations buy. They are looking for shows that deliver viewers because
the price of advertising on television depends on the number of people watching
the show (and therefore the commercials). This is why advertising on the Super
Bowl is so expensive.
This is an over-simplified description of the broadcast television business
model, but it will do. The point is to note what the relevant benefits are, and how
these benefits impact content. The broadcast TV model wants viewers who can
be sold to advertisers. Suppose that television tastes were normally distributed
(i.e., the tastes of viewers can be represented by the bell curve). What part of the

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bell curve would TV content providers aim for? Of course, they aim for the middle
where the bulk of the viewers are. Do you think they would have an interest in a
show that might be very different and innovative and appealing to the fringes?
The answer is no because the numbers are not on the fringes. As a
consequence, broadcast TV content tends to gravitate to the bland middle the
shows all seem pretty similar.
HBO makes money when cable and satellite providers carry HBO
programming. Cable and satellite providers will subscribe to HBO if HBO brings
them cable and satellite TV subscribers. Note that HBO is not looking for a large
viewing audience as much as it is looking for people who want to subscribe to
HBO (via a cable or satellite subscription). For simplicity, we are ignoring the
possibility that the cable station might sell advertisement around HBO content.
Again, this is an oversimplified description of the HBO model, but it is
sufficient to make the connection between content and programming. Rather
than shoot for a larger viewing audience for a show, HBO wants to appeal to the
largest group of potential subscribers. The best way to appeal to a potential
subscriber is to offer something on HBO that they will not find elsewhere. This
has lead HBO to seek out different types of programming to appeal to a broad
spectrum of tastes. The key point here is that they do not have to appeal to
viewers on a per show basis, but rather on a combined programming basis. Not
everyone likes the Sopranos or Six Feet Under or boxing matches. But HBO
does not have to get everyone to like all of its shows; it just has to get you
passionately involved in any one of them to make you a subscriber.
As a consequence, HBO programming has been bold, innovative, and
deliberately diverse. This has been reflected in Emmy Awards. HBO and similar
providers have routinely won more awards for their shows than their broadcast
television counterparts. The difference is not a matter of talent as much as it is a
matter of different relevant benefits in different business models.

Application: The Costs and Benefits of DeBeers Unique Diamond

Distribution
The DeBeers Group started out as a South African diamond mining firm
that until recently had a near-monopoly on the gem-quality diamond market. It
attained its monopoly by controlling access to South African diamond mines, long
one of the few places in the world where gem-quality diamonds could be
economically recovered. For decades, DeBeers was also able to come to terms
with its primary competitor, the Soviet Union. It seems that monopolists and
Bolsheviks need not be such strange bedfellows.
But DeBeers monopoly is not the topic here; its very unique (and strange)
distribution practices are. DeBeers currently produces about 40 percent of the
worlds raw diamonds and is responsible for marketing another 30 percent. With
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its marketing of almost three-quarters of the worlds raw diamonds, it is not a

monopoly, but certainly the major player in the market.
The Diamond Trading Company of London (usually referred to simply as
DTC) is the unit of DeBeers that handles the wholesaling of raw diamonds to
diamond cutters and jewelers. DTC schedules a sight for buyers every five
weeks. At a sight, a very select group of sightholders about 100 diamond
wholesalers go to DTC to purchase raw diamonds. The sightholders had
previously submitted their specifications weight, shape, and color for
diamonds that they want to purchase from DTC. In turn, DTC has selected the
stones to fill the sightholder orders, boxed the stones, set a price for the lot, and
then stored them until the sight.
At the sight, the sightholders pay for the box of diamonds in advance,
sight-unseen. There is no bargaining or haggling and the stones are not
individually returnable; the sightholder can only refuse the box, but cannot refuse
individual stones. If a sightholder refuses a box, the buyer will be refunded the
purchase price, but will not be invited to future sights and will no longer be a
sightholder.
This is a rather strange arrangement and one that most people do not
expect to encounter in such a prestigious market. It also seems to work well. The
primary criterion for saying that the arrangement works well is its longevity. The
practice persists; but why?
Some might simply conclude that DeBeers uses its monopoly power to
force sightholders to pay in advance on a take-it-or-leave-it basis. However, while
market power might play a part, it is probably a small part. Understanding this
practice requires an understanding of its costs and benefits.
See if you can explain why the sight practice persists by addressing the
following questions:
1. What is the advantage to DeBeers of using this arrangement to
distribute diamonds?
2. What is the cost to a sightholder of refusing a DTC box?
3. What is the benefit to sightholders of having DTC select the
diamonds that meet the sightholders specifications?
4. What are the costs to sightholders of having DTC select the
diamonds that meet the sightholders specifications?
5. By all accounts, DTC has an excellent track record of matching
diamonds to sightholder specifications. How does this impact the
benefit/cost trade-off of this arrangement for sightholders? If DTC

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was less proficient at matching specifications to stones, how would

this impact the persistence of the sight system?

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