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## Cost-benefit analysis

Current time:0:00Total duration:5:08

# Optimal Decision-making and opportunity costs

AP Micro: CBA‑1 (EU), CBA‑1.A (LO), CBA‑1.A.1 (EK), CBA‑1.B (LO), CBA‑1.B.1 (EK)

## Video transcript

- [Instructor] What we're
going to do in this video is think about optimal decision
making by rational agents. And it's just thinking
about how would a logical, someone with a lot of reasoning ability, make optimal decisions, make the best decisions for themselves? Well they would look at the
costs and benefits of a decision and they would try to do
the action that maximizes the difference between benefits and costs. So they would wanna maximize benefits, benefits minus costs. And this is an important
idea because I think all of us would like
to be rational agents, logical agents, making optimal decisions. Now when we think about
benefits and costs, benefits you might try
to quantify it somehow, maybe in terms of dollars. What's the benefit of say going to a movie or having some ice cream? And costs, we tend to
associate with a price, the cost of going to a
movie say might be $10. Those types of things are
known as explicit costs, when there's an explicit
price associated with it. But there's also something
known as implicit costs, and the most well-defined implicit cost is the idea of an opportunity cost. And the opportunity cost in economic terms is defined as the cost of
the next best alternative. So if I'm going to go to
a movie, there might be the explicit costs of
paying for the movie, but then there's the implicit cost. Maybe if I'm going to a movie,
that time I could've used for something else. Maybe I could've earned money somehow. And so a rational actor
would consider both of those and then compare them to the
benefit of going to the movie, and if that's what
maximizes the difference between benefits and
costs, well they might decide to do that. Now to make this a
little bit more tangible, let's look at that exact example. So right over here, we are told, suppose you have the choice
between going to a movie for three hours versus
working for three hours. Movie tickets cost $10. If you work, you can earn
$30 an hour mowing lawns, $12 an hour working in an ice cream shop, or $10 an hour weeding your aunt's garden. What is the opportunity
cost of going to a movie for three hours? And what is the total cost? So pause this video and see
if you can figure that out. All right well we just have
to go back to the definition. The opportunity cost is the cost of the next best alternative. So what is the next best
alternative to going to the movie? Well, I can make the most
money if I am mowing lawns, if I am mowing lawns. And so my opportunity cost
is going to be $30 an hour, and if I'm going to a movie,
that would've been three hours that I would not have
been able to mow lawns. And so my opportunity cost, I'll write OC, I'm not talking about Orange County, the opportunity cost right
over here is going to be $30 an hour times three hours, so 30 times three, which
is going to be a $90, $90 opportunity cost. Now some of you might be
saying, well what about the $12 an hour for an ice
cream shop or $10 an hour for weeding your aunt's garden? Well, those weren't the
next best alternative. The next best alternative
was mowing the lawn. Some people might be confused and say, okay I'm gonna add all of
these together per hour and multiply by three, but
you're not gonna be able to do all three of these things. You're going to have to pick one of them. And we're assuming that maybe
there aren't any extra costs that are not, maybe you get
extra tired from mowing lawns versus working in an ice cream shop, but we're trying to simplify things, so let's not get overly
complicated right now. So at a very face level
or at a high level, the next best alternative is making $30 an hour mowing lawns. So that would be the opportunity cost. Now what would be the total cost? Well the total cost would be
the sum of the implicit costs, which is opportunity cost
is an example of that, plus the explicit cost. So the implicit costs, we
already talked about that, that is $90. That's the cost of not,
that's the opportunity cost of not mowing lawns. And then to that you're
gonna add the explicit cost of just the price of the movie ticket. For $10 you get to watch
a movie for three hours. So there's a $10 explicit cost. So the total cost of going
to the movie is $100. And so how would an optimal decision or how would a rational
agent use this information to make an optimal decision? Well they would wanna
compare that to the benefit of going to a movie. And so if they could
quantify that benefit somehow and say oh, yeah, the benefit
to me of going to a movie is $200 and that difference
between $200 and $100, that's the best difference that I can get out of all of my choices between
my benefits and my costs. Well then I'm going to go to that movie. So I will leave you there
and in future videos, we'll dig a little bit deeper into this.