AP® Microeconomics review sheet from Aim for Five (aimforfive.com/micro/units/1/1-5)
Unit 1 · Topic 1.5
1.5 Cost-Benefit Analysis
Cost-benefit analysis means comparing everything you gain from a choice with everything it costs, including costs no one bills you for. You pick the option with the biggest net benefit. This is the 'all-or-nothing' version of decision making; topic 1.6 covers the step-by-step marginal version.
Key terms
- explicit cost
- implicit cost
- total benefit
- total cost
- net benefit
- utility
Explicit and implicit costs
An explicit cost is a payment you actually make: rent, tuition, wages paid to workers, the price of materials.
An implicit cost is the value of something you give up without paying money for it: the salary you didn't earn because you ran your own business, the interest your savings could have earned, or the hours you spent.
Total cost, in the economic sense, is explicit costs plus implicit costs. That total is the full opportunity cost of the choice. Leaving out implicit costs makes options look cheaper than they are.
Total benefit and net benefit
Total benefit is the full value you get from a choice. For a consumer, benefit is measured as utility, the satisfaction or happiness a good gives you. For a firm, benefit is total revenue, the money it takes in from sales.
Net benefit = total benefit − total cost. A rational decision maker (someone who weighs costs and benefits to reach their goal) picks the option with the largest net benefit. If every option has a negative net benefit, the best choice is to do none of them.
| Decision maker | Benefit measured as | Cost includes | Goal |
|---|---|---|---|
| Consumer | utility (satisfaction) | price paid plus time and other things given up | maximize net benefit (utility minus cost) |
| Firm | total revenue | explicit costs plus implicit costs | maximize profit (revenue minus all costs) |
All-or-nothing decisions
Some decisions can't be split into small steps. You either take the job in another city or you don't; a company either builds the factory or it doesn't. For these, compare totals: total benefit against total cost, including implicit costs.
Other decisions come in steps: how many hours to study, how many slices of pizza to eat, how many workers to hire. For those, it's easier to compare the benefit and cost of each extra step, which is marginal analysis (topic 1.6). Both methods lead to the same best choice when you use them correctly.
Picking the best option
When options are listed with their benefits and costs, the best choice is the one with the biggest gap between the two. Watch out for two tempting wrong answers: the option with the highest total benefit (it may cost too much) and the option with the lowest cost (it may deliver too little).
Costs already paid and impossible to get back, called sunk costs, don't belong in the comparison. They're the same no matter what you choose next, so they can't change which option is best. Topic 1.6 returns to this.
Worked examples
Try each one yourself first, then open the solution.
- Example 1Calculator allowed
Including implicit costs
Jordan is deciding whether to attend a summer coding camp. Tuition is $1,200 and materials cost $100. If he attends, he can't take a summer job that pays $2,400. He values what he'd learn at $3,000. Should he go? What mistake would lead to the wrong answer?
Show the solutionHide the solution
- Step 1: Explicit costs: $1,200 + $100 = $1,300.
- Step 2: Implicit cost: the $2,400 in summer wages he gives up.
- Step 3: Total cost = $1,300 + $2,400 = $3,700.
- Step 4: Net benefit = $3,000 − $3,700 = −$700. The camp costs more than it's worth to him, so he shouldn't go.
- Step 5: The trap: counting only explicit costs gives $3,000 − $1,300 = +$1,700, which makes the camp look like a good deal.
Answer: No. The net benefit is −$700 once the $2,400 implicit cost is counted.
- Example 2Calculator allowed
Choosing by net benefit
A city is choosing one park plan. Plan A has a total benefit of $50,000 and a total cost of $30,000. Plan B: benefit $80,000, cost $55,000. Plan C: benefit $100,000, cost $90,000. Which plan should it choose?
Show the solutionHide the solution
- Step 1: Plan A net benefit = $50,000 − $30,000 = $20,000.
- Step 2: Plan B net benefit = $80,000 − $55,000 = $25,000.
- Step 3: Plan C net benefit = $100,000 − $90,000 = $10,000.
- Step 4: Plan B has the largest net benefit. Plan C has the biggest total benefit and Plan A the lowest cost, but neither leaves the most left over.
Answer: Plan B, with a net benefit of $25,000.
Common mistakes
- Leaving out implicit costs such as forgone wages or forgone interest. They're part of the true cost of a choice.
- Choosing the option with the highest total benefit or the lowest cost instead of the largest net benefit.
- Counting a sunk cost. Money already spent and not recoverable is the same whichever option you pick, so it shouldn't affect the decision.
- Thinking 'benefit' means only money. For consumers, benefit is utility, even when no cash is involved.
On the exam
- Questions often describe a person or firm's choice and ask which costs are explicit and which are implicit, or which option a rational decision maker would choose.
- This topic sets up economic profit in topic 3.4, which also subtracts implicit costs, so get comfortable listing both kinds of cost now.
Connected topics
Videos
Check yourself
4 questions on 1.5 Cost-Benefit Analysis. Pick an answer to see if you got it, and why.
Leah quits a job that paid her $40,000 a year to run a food truck.
In her first year, the food truck brings in $70,000 in revenue.
She pays $25,000 for food, fuel and permits. She owns the truck, which she could otherwise have rented out for $3,000 a year.
Hypothetical scenario
What are Leah's explicit costs for the year?
Counting both explicit and implicit costs, what is Leah's net benefit from running the food truck for the year?
Which of the following is an implicit cost of Leah's decision?
| Plan | Total benefit | Total cost |
|---|---|---|
| 1 | $50 | $20 |
| 2 | $80 | $45 |
| 3 | $100 | $70 |
| 4 | $120 | $95 |
Hypothetical options for a school club fundraiser (choose one plan)
The club can choose only one of the four plans. Which plan should a rational decision maker choose?
0 of 4 answered