## Evaluating Different Market StructuresDecember 13, 2012

Posted by tomflesher in Micro, Teaching.
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Market structures, like perfect competition, monopoly, and Cournot competition have different implications for the consumer and the firm. Measuring the differences can be very informative, but first we have to understand how to do it.

Measuring the firm’s welfare is fairly simple. Most of the time we’re thinking about firms, what we’re thinking about will be their profit. A business’s profit function is always of the form

Profit = Total Revenue – Total Costs

Total revenue is the total money a firm takes in. In a simple one-good market, this is just the number of goods sold (the quantity) times the amount charged for each good (the price). Marginal revenue represents how much extra money will be taken in for producing another unit. Total costs need to take into account two pieces: the fixed cost, which represents things the firm cannot avoid paying in the short term (like rent and bills that are already due) and the variable cost, which is the cost of producing each unit. If a firm has a constant variable cost then the cost of producing the third item is the same as the cost of producing the 1000th; in other words, constant variable costs imply a constant marginal cost as well. If marginal cost is falling, then there’s efficiency in producing more goods; if it’s rising, then each unit is more expensive than the last. The marginal cost is the derivative of the variable cost, but it can also be figured out by looking at the change in cost from one unit to the next.

Measuring the consumer’s welfare is a bit more difficult. We need to take all of the goods sold and meausre how much more people were willing to pay than they actually did. To do that we’ll need a consumer demand function, which represents the marginal buyer’s willingness to pay (that is, what the price would have to be to get one more person to buy the good). Let’s say the market demand is governed by the function

QD = 250 – 2P

That is, at a price of $0, 250 people will line up to buy the good. At a price of$125, no one wants the good (QD = 0). In between, quantity demanded is positive. We’ll also need to know what price is actually charged. Let’s try it with a few different prices, but we’ll always use the following format1:

Consumer Surplus = (1/2)*(pmax – pactual)*QD

where pmax is the price where 0 units would be sold and QD is the quantity demanded at the actual price. In our example, that’s 125.

Let’s say that we set a price of $125. Then, no goods are demanded, and anything times 0 is 0. What about$120? At that price, the quantity demanded is (250 – 240) or 10; the price difference is (125 – 120) or 5; half of 5*10 is 25, so that’s the consumer surplus. That means that the people who bought those 10 units were willing to pay $25 more, in total, than they actually had to pay.2 Finally, at a price of$50, 100 units are demanded; the total consumer surplus is (1/2)(75)(100) or 1875.

Whenever the number of firms goes up, the price decreases, and quantity increases. When quantity increases or when price decreases, all else equal, consumer surplus will go up; consequently, more firms in competition are better for the consumer.

Note:
1 Does this remind you of the formula for the area of a triangle? Yes. Yes it does.
2 If you add up each person’s willingness to pay and subtract 120 from each, you’ll underestimate this slightly. That’s because it ignores the slope between points, meaning that there’s a bit of in-between willingness to pay necessary to make the curve a bit smoother. Breaking this up into 100 buyers instead of 10 would lead to a closer approximation, and 1000 instead of 100 even closer. This is known mathematically as taking limits.

## Duopoly and Cournot EquilibriumDecember 12, 2012

Posted by tomflesher in Micro, Teaching.
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A few days ago, we discussed perfectly competitive markets; yesterday, we talked about monopolistic markets. Now, let’s expand into a case in between – a duopolistic, or two-seller, market. This is usually called a Cournot problem, after the economist who invented it.

We’ll maintain the assumption of identical goods, so that consumers won’t be loyal to one company or the other. We’ll also assume that each company has the same costs, so we’re looking at identical firms as well. Finally, assume that there are a lot of buyers, so the firms face a market demand of, let’s say, QD(P) = 500 – 2P, so P = 250 – QD(P)/2. Since the firms are producing the same goods, then QS(P) = q1(P) + q2(P).

Neither firm knows what the other is doing, but each firm knows the other is identical to it, and each firm knows the other knows this. Even though neither firm knows what’s going on behind the scenes, they’ll assume that a firm facing the same costs and revenues is rational and will optimize its own profit, sothey can make good, educated guesses about what the other firm will do. Each firm will determine the other firm’s likely course of action and compute its own best response. (That’s the one that maximizes its profit.)

Now, let’s take a look at what the firms’ profit functions will look like.

Recall that Total Profit = Total Revenue – Total Cost, and that Marginal Profit = Marginal Revenue – Marginal Cost. Companies will choose quantity to optimize their profit, so they’ll continue producing until their expected Marginal Profit is 0, and then produce no more. Firm 1’s total revenue is Pxq1 – revenue is always price times quantity. Keeping in mind that price is a function of quantity, we can rewrite this as (250 – QD(P)/2)xq1. Since QD(P) = q1 + q2, this is the same as writing (250 – (1/2)(q1 + q2))q1. Then, we need to come up with a total cost function. Let’s say it’s 25 + q12, where 25 is a fixed cost (representing, say, rent for the factory) and q12 is the variable cost of producing each good. Then, Firm 1’s profit function is:

Profit1 = (250 – (1/2)(q1 + q2))q1 – 25 – q12

or

Profit1 = (250 – q1 /2 – q2/2)q1 – 25 – q12

or

Profit1 = 250q1 – q12/2 – q1q2/2 – 25 – q12

The marginal profit is the change in the total profit function if Firm 1 produces one more unit; in this case it’s easier to just use the calculus concept of taking a derivative, which yields

Marginal Profit1 = 250 – q1 – q2/2 – 2q1 = 250 – 3q1 – q2/2

Since the firms are identical, though, firm 1 knows that firm 2 is doing the same optimization! So, q1 = q2, and we can substitute it in.

Marginal Profit1 = 250 – 3q1 – q1/2 = 250 – 5q1/2

This is 0 where 250 = 5q1/2, or where q1 = 100. Firm 2 will also produce 100 units. Total supplied quantity is then 200, and total price will be 200. We can figure out each firm’s profit simply by plugging in these numbers:

Total Revenue = Pxq12 = 200×100 = 20,000

Total cost = 25 + q12 = 25 + 100×100 = 25 + 10,000 = 10,025

Total Profit = 9,075

This was a bit heavier on the mathematics than some of the other problems we’ve talked about, but all that math is just getting to one big idea: it’s rational to produce when you expect your marginal benefit to be at least as much as your marginal cost.

## Monopolistic MarketsDecember 11, 2012

Posted by tomflesher in Micro, Teaching.
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Continuing our whistle-stop tour through market types, today’s topic is monopolies. Yesterday’s discussion was of perfectly competitive markets, where three conditions held:

• Identical goods
• Lots of sellers

Today, we’ll talk about what happens when that second condition doesn’t hold – that is, when sellers have market power. When sellers don’t have market power, they have to price according to what the market will bear. If they price too high, someone will undercut them, but if they price too low, they’ll lose money. The only thing they can do is price at their break-even point, where price is equal to marginal cost. (This is sometimes called the zero profit condition.)

When only one seller exists, he is called a monopolist, and the market is called a monopoly. A monopoly can arise for one of two reasons: either it can be because the owner has exclusive access to some important resource, called a natural monopoly, or the owner has an ordinary monopoly because of laws, barriers to entry, or some other reason.

A natural monopoly is one that arises not because of anticompetitive action by the monopolist but because of exclusive access to some resource. For example, owning a waterfall means you have unbridled access to it for hydroelectric purposes; being the first to lay cable or pipelines makes it inefficient for anyone else to access those resources; essentially, anything where there’s a high fixed cost and a zero marginal cost are good candidates for natural monopoly status.

Regardless of whether a monopoly is natural or ordinary, a monopolist isn’t subject to the same zero-profit condition as he would be in a perfectly competitive market, since there’s no one to undercut him if he prices higher than his own marginal cost. He’s free to do the absolute best he can – in other words, to maximize his profit. The monopolist doesn’t have to take the price, as a perfectly competitive market would force him to; he’ll choose the price himself by choosing the quantity he produces.

The monopolist’s profit-maximization condition is that his marginal revenue = marginal cost. This derives from the monopolist’s profit function, Profit = Total Revenue – Total Cost. The monopolist will produce as long as each unit provides positive profit – in other words, as long as marginal profit ≥ 0. In non-economic terms, he’ll continue producing as long as it’s worth it for him – as long as each extra unit he produces gives him at least a little bit of profit. Once his marginal profit is 0, there’s no point in producing any further, since every unit he produces will then cost him a little bit of profit. Because Profit = Total Revenue – Total Cost, another equation holds: Marginal Profit =Marginal Revenue – Marginal Cost. Saying that marginal profit is nonnegative means exactly that marginal revenue is at least as much as marginal cost.

Finally, note that marginal revenue is the price of the last (marginal) unit, but keep in mind that the monopolist has control over the quantity that’s produced. Thus, he has control over the price, and will choose quantity to get his optimal profit.

## Perfectly Competitive MarketsDecember 10, 2012

Posted by tomflesher in Micro, Teaching.
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When solving economic problems, the type of firm you’re dealing with can lead you to use different techniques to figure out the firm’s rational choice of action. This week, I’ll set up a thumbnail sketch of how to solve different firms’ types of problems, since a common exam question in intermediate microeconomics is to set up a firm’s production function and ask a series of different questions. The important thing to remember about all types of markets is that every economic agent is optimizing something.

In a perfectly competitive market, three conditions hold:

• All goods are identical. If the seller is selling apples, then all apples are the same – there are no MacIntosh apples, no Red Delicious apples, just apples.
• There are lots of sellers, so sellers can’t price-fix because there will always be another seller who will undercut.
• There are lots of buyers, so a buyer boycotting won’t make a difference.

The last two conditions sum up together to mean that no one has any market power. That means, essentially, that no action an individual buyer or seller takes can affect the price of the goods. If ANY of these conditions isn’t true, then we’re not dealing with a perfectly competitive market – it might be a monopoly or a monopsony, or it might be possible to price-discriminate, but you’ll have to do a bit more to find an equilibrium.

Speaking of that, an equilibrium in microeconomics happens when we find a price where buyers are willing to buy exactly as much as sellers are willing to sell. Mathematically, an equilibrium price is a price such that QS(P) = QD(P), where QS is the quantity supplied, QD is the quantity demanded, and the (P) means that the quantities depend on the price P. Since the quantity is the same, economists sometimes call an equilibrium quantity Q* and the equilibrium price P*.

Consumers are optimizing their utility, or happiness. This might be represented using something called a utility function, or it might be aggregated and presented as a market demand function where the quantity demanded by everyone in the world is decided as a function of the price of the good. A common demand function would look like this:

QD(P) = 100 – 2*P

That means if the price is $0, there are 100 people willing to buy one good each; at a price of$1, there are (100 – 2*1) = 98 people willing to buy one good each; and so on, until no one is willing to buy if the price is $50. Demand curves slope downward because as price goes up, demand goes down. Essentially, a demand function allows us to ignore the consumer optimization step. Demand represents the marginal buyer’s willingness to pay; price equalling willingness to pay is something to remember. Firms optimize profit, which is defined as Total revenue, minus total costs. If we have a firm’s costs, we can figure out how much they’d need to charge to break even on each sale. Let’s say that it costs a firm$39 to produce a each good. They won’t produce at all until they’ll at least break even – or, until their marginal benefit is at least equal to their marginal cost, at which point they’ll be indifferent. Then, as the price rises above $39, charging more will lead to more profit. Even if the firm’s marginal cost changes as they produce more unity, the price of the marginal unit will need to be at least as much as the marginal cost for that unit. Otherwise, selling it wouldn’t make sense. The first condition to remember when solving microeconomics problems is that in a perfectly competitive market, a firm will set Price equal to Marginal Cost. If you have price and a marginal cost function, you can find the equilibrium quantity. If you have supply and demand functions, set QS(P) = QD(P) and solve for the price, or simply graph the functions and figure out where they meet. ## When is a filibuster not a filibuster?December 7, 2012 Posted by tomflesher in Micro, Models, Teaching. Tags: , , , , , , , add a comment A filibuster is a legislative technique where a lawmaker who is in the minority will block passage of the bill. Historically, that required talking continuously on the legislature floor, as that would prevent anyone else from doing anything. In the US Senate, a bill can be filibustered simply by declaring it so – the filibustering Senator doesn’t actually need to talk. The Senate is considering a rule change to move back to historical, “talking” filibusters. In either case, a filibuster can be broken by a 60-vote supermajority (called cloture), but a talking filibuster can also be broken by the filibustering Senator getting tired and quitting. What’s the economic difference between these two rules? The fact is that talking imposes an extra cost on the filibustering party. When people are The model:1 First, like all good economists, let’s make some simplifying assumptions. Say there are two parties, the Bears and the Bulls, and that there are 59 Bears and 41 Bulls. Assume that everyone votes strictly along party lines, so every vote comes out in favor of the Bears 59-41. That’s not enough for a 60% majority, so under the current system, the Bulls can filibuster every bill without stopping other legislation. Parties aim to maximize their political capital, which is generated in two ways: • Passing bills. The more partisan a bill is, the more capital is generated. A bill that the entire country would agree to pass has zero partisanship; a bill only Bears would vote for has a very high partisanship. The minority party generates goodwill based on voting for bills, but it decreases when the bills are more partisan. • Public perception (goodwill). Filibustering leads to a negative public perception. This is directly related to how partisan a bill is – filibustering a totally nonpartisan bill (discount bus fares for war widows) would lead to a highly negative perception, but filibustering a very contentious bill would be offset. Similarly, a filibuster stops all business, so the longer it goes on, the angrier people get. The Bulls’ capital generation would look like this, with the “talking filibuster” term last, P=Partisanship and D = Days spent filibustering: $C = - P^2+ 41*P - \frac{1}{P}*D^2$ Under the current system, days spent filibustering is 0, since nobody actually has to filibuster. That is, the marginal cost of filibustering a bill is 0. If a bill passes, the Bulls generate 41 political capital per unit of partisanship for voting, but lose some capital for losing the vote. If a bill has Partisanship of 20.5, then the Bulls are indifferent between filibustering and allowing the vote; anything more partisan will definitely be filibustered, and anything less partisan will be voted on. If talking filibusters are required, though, the whole thing gets much more complicated. Adding a marginal cost for being on TV filibustering makes the minority party far less likely to filibuster. The marginal political capital generated for filibustering for one day is $MCapital = -2*P + 41 + \frac{1}{P^2}$ The Bulls are indifferent between filibustering and allowing the vote when Partisanship is about 20.5012. That’s just what we’d expect – that it takes a more contentious bill to justify a talking filibuster than a silent filibuster. Then, let’s take a look at a two-day filibuster: $MCapital = -2*P + 41 + \frac{4}{P^2}$ A slightly longer filibuster requires a slightly more controversial bill, requiring Partisanship to be 20.5048. Finally, let’s take a look at a 90-day (3-month) filibuster: $MCapital = -2*P + 41 + \frac{8100}{P^2}$ That would require a bill of partisanship 26.338. The model displays the expected features: that it takes a more contentious bill to merit a filibuster at all, and longer filibusters require much more contentious bills. If we raise the costs of doing something, it becomes used less often. Note: 1 As far as I know, this isn’t stolen from anyone, but if it’s similar to one currently in the literature please let me know so I can do some reading and properly credit the inventor. ## It’s For The Public GoodDecember 6, 2012 Posted by tomflesher in Micro, Teaching. Tags: , , , , , , add a comment There are several types of goods in economics: private goods, public goods, club goods, and common goods. What defines which category a good will fall into? The category can be determined knowing two things: Is the good rival? Is it excludable? If a good is rival, one person using it prevents someone else from using it. This is a bit of a weird concept, since air can only be breathed by one person at a time, but air is so abundant as to be nonrival. Air in a SCUBA tank, though, would be rival, since only one person can breathe from it at a time. If a good is excludable, you can prevent someone from using the good if you don’t want them to. My apartment is excludable because I have a lock on the door. Private goods are rival and excludable. Just about anything you can think of going to a store and buying is a private good. My TI-36X Pro calculator is rival (if you’re using it, I can’t) and it’s excludable (if I don’t want you to use it, I’ll just put it in my pocket). Private goods have some interesting properties and merit further discussion. Public goods are defined as goods that are nonrival and nonexcludable. The classic example of a public good is military defense. If the Army exists and prevents other countries from invading the United States, then there’s no way to keep me from benefiting from that defense that doesn’t also prevent someone else (e.g., my no-good brother) from benefiting (so defense is nonexcludable). Similarly, defending the United States is nonrival because the fact that I’m defended doesn’t have any effect on how defended someone else is. I don’t use up military defense, so it doesn’t (in the simplest case) cost anything to defend my neighbor if I’m already being defended. Club goods are excludable but nonrival. My landlord’s wireless internet connection is a club good. It’s excludable, because there’s a password on it; it’s nonrival, though, because up to a certain point it doesn’t matter how many people are connected to the network. My enjoyment of the internet doesn’t depend on whether my wife is online or not. (It would take a whole bunch of people, enough to cause congestion, to make my internet too slow to use.) Common goods are pretty interesting, because there’s an intuitive concept called the tragedy of the commons. Common goods are rival, but nonexcludable. The classic example here is a meadow where you graze your sheep. Every one of us can use the meadow, since it’s public property, but if I graze my sheep here, they eat some of the grass and there’s less for your sheep. It’s in both of our interests to conserve the meadow, but it’s also in both of our interests to cheat and consume as much as we want to. Common goods tend to get used up. What goods seem to straddle the line between two of these categories, and how do you think that confusion can be resolved? ## Scribbling in the MarginsDecember 5, 2012 Posted by tomflesher in Micro, Teaching. Tags: , , , , , , , 1 comment so far 3. Rational people think at the margin. That’s one of Mankiw’s Ten Principles of Economics. (#3, in fact). What does it mean? The usual definition of “marginal” is “additional.” In other words, the marginal cost of something is the cost of buying another one. So, we can rephrase Number Three as “Rational people think about the next one of whatever it is they’re thinking about.” We can also think about marginal benefits. How much would you pay for a Dove Dark Chocolate bar?1 Whatever your answer, that’s the benefit that a Dove bar affords you. Currently, I have zero Dove bars, so the first Dove bar I bought would give me a benefit. Economists measure benefit in two ways: either in utility, which is an abstract concept of “happiness points,” or in dollars, which are, well, dollars. If I’d pay$1.50 for a Dove bar, then my marginal benefit for a Dove bar is $1.50. Because this sounds simple, economists sometimes make this sound more complicated by calling it money-metric utility. After I eat the first Dove bar, I really wouldn’t want another 0ne – at least, not as much as the first. I’m willing to pay$1.50 for the first one, but $1.50 would be too much for the second. I might buy two if they’re on special for two for$2.50, but I wouldn’t pay much more than that. That means I value the second Dove bar at $1.00, or the benefit I’d get from two bars minus the benefit I’d get from one bar.2 This is pretty normal – marginal benefits, or marginal utility, is decreasing in quantity for most goods. That’s just a fancy way of saying that the second one isn’t as good as the first, and the third isn’t as good as the second. The technical term for that is diminishing marginal returns. The marginal cost is just the cost of the additional bar. Usually, stores have one price per bar, no matter how many you buy. My local grocery store sells Dove Bars for$1.25 each. Since I’d pay $1.50 for that bar, I’d buy it, and I’d be better off to the tune of$0.25 because I got $1.50 worth of utility for only$1.25. (Economists call that $0.25 consumer surplus.) Should I buy the second one? If you make the decision all at once, you’d say that I value two bars at$2.50, so why not? Here’s the problem: that gives me a total benefit of $2.50 at a total cost of$2.50, for a consumer surplus of $0. If I buy the first bar, I get a consumer surplus of$0.25. Buying the second bar amounts to paying $1.25 for something I only value at$1, so I’d get a consumer surplus of -$0.25. Thinking at the margin allows me to spend that last$1 on something I actually value that much.

The fundamental criterion for making decisions in economics: do something  only if its Marginal Benefit is at least as much as its Marginal Cost. In other words, don’t buy something unless you’re at least breaking even.

Note:
1 Okay, that’s a 24-pack. How much would you pay for a 24-pack? Probably not more than 24-times-your-valuation. But we’ll chat about that later.
2 Mathematically, marginal benefit is defined as $\frac{\Delta(Benefit)}{\Delta(Quantity)}$, with Δ meaning “change.” Here, the change in benefit is $1.00 and the change in quantity is 1. ## Budgets and Opportunity CostJanuary 19, 2012 Posted by tomflesher in Finance, Micro, Teaching. Tags: , , , , add a comment In the previous entry, we talked a little about opportunity cost. In short, it’s what someone gives up in order to acquire something else. What does that have to do with budgeting? Start with the plain-sense definition of a budget. Most people think of a budget – quite correctly – as a list of planned expenses by category. I might plan out my week’s spending as: •$30: gas
• $200: planned monthly expenses (rent, insurance, utilities) •$50: groceries
• $40: a meal out •$30: savings
• $50: petty cash (Starbucks, forgot my lunch, that sort of thing) That comes out to$400. What does that tell me? Well, for it to be a good budget, I’d better not make any less than $400 a week! Otherwise, I’m planning to spend more than I make, and that’s going to get me into trouble shortly. (If I spend myself into a deficit, I’ll need to plan to get out at some point.) It also tells me that I expect to make no MORE than$400 this week. After all, I have a spot for savings and a spot for petty cash, so I have places for overflow. Petty cash is what some people call slack,where anything “extra” would go.

Let’s simplify just a little. Let’s say I have that same $400 income, but I can only spend it on two things: coffee and sweaters. Sweaters cost$25 each, and coffee costs $2 per cup. I have a couple of choices – in fact, an infinite number of them – for how I can spend that money. For example, if I want to spend all my money on coffee, I can buy $\frac{400}{2} = 200$ cups of coffee. If I want to spend all my money on sweaters, I can buy $\frac{400}{25} = 16$ of them. Of course, there’s no reason to spend all my money on one of those two goods. I can buy any combination, subject to the budget constraint that I don’t create a deficit: that is, that $2*(cups\:of\:coffee) + 25*(sweaters) \le 400$ Think back to when we talked about opportunity cost: if I have the same budget either way, then think about how many cups of coffee I have to give up to get a sweater. There are a couple of ways to do this, but the easiest is to compare the prices: for$25, I get one sweater or 12.5 cups of coffee, so the opportunity cost of one sweater is 12.5 cups of coffee. Similarly, for $2, I get one cup of coffee or 1/12.5 = .08 sweater, so my opportunity cost of buying a cup of coffee is 8% of a sweater. Note that this is the same as dividing the total quantities I can buy: $16\:sweaters = 200\:cups$ $1\:sweater = \frac{200}{16}\:cups$ $1\:cup = \frac{16}{200}\:sweaters$ Basically, we can use a budget constraint to determine opportunity costs by imagining that we spend our entire budget on each of two goods and then comparing the quantities, or simply by comparing prices. Opportunity costs represent budgeting decisions on a much smaller – some might say marginal – scale. ## Opportunities and What They CostDecember 23, 2011 Posted by tomflesher in Finance, Micro, Teaching. Tags: , , , , , add a comment One of the fundamental concepts in economics is that of opportunity cost. In order to understand opportunity cost, though, we need to take a step back and think about costs in a more general way. The standard example goes like this: I like books, so I want to turn my passion into a job and open a bookstore. To do so, I need to rent a storefront and buy some inventory; for now, I’m going to run the bookstore myself. I’ll be open eight hours a day, so I’ll quit my current job at the box factory and do the bookstore job instead. Easy peasy, right? I even have$100,000 in the bank to get myself started.

Let’s look at the costs. The first thing to consider is the actual money I’m laying down to run this business. Say rent is $1,000 per month. If I don’t want to bother with discounting – and for now, I don’t – then that means I’ve spent$1,000 x 12 = $12,000 on rent this year. Then, imagine that in order to meet demand and still have a decent inventory, I need to spend$43,000 on books. That brings me up to $55,000 worth of cash that I’m laying out – my explicit costs, otherwise known as accounting costs, are$55,000.

But accounting costs don’t show that I had to give up my job at the box factory to do this, and I could have made $45,000. They also don’t account for the interest income I’m giving up by pulling my money out of the bank to live on it. Even if interest rates are only 1.25 APR (that’s annual percentage rate), I’m losing$1,250 in interest income. So, for simplicity (I don’t want to bother with compounding, either), let’s assume that in January I take out this year’s $45,000 in salary and keep it under my mattress. I buy my inventory and pay my rent. I’ve given up$1,250 in interest income and $45,000 in salary, so even though I haven’t laid out that cash, I have to count it as a cost. Accountants won’t write down what I gave up on a balance sheet, but my implicit costs, or opportunity costs, are$46,250.

Total costs are simple – just add implicit and explicit costs. My total costs for starting the business are $55,000 +$46,250 = \$101,250.

The key to understanding opportunity cost is that it’s a measure of what you gave up to make a choice, and so it shows how much something is worth to you. If I offer you a free Pepsi, your opportunity cost is zero, so you might as well take it. If I offer you a Pepsi for your Dr. Pepper, we can infer two things:

1. I value Dr. Pepper at least as much as Pepsi, and
2. I can figure out how much you value Dr. Pepper, relatively, based on your decision. If you accept, then you must value Pepsi at least as much as Dr. Pepper; if not, you must value Dr. Pepper more (and would thus be rational, since Dr. Pepper is superior to Pepsi).

Opportunity cost is very useful for determining preferences. We’ll talk about that a little more later on. In the meantime, just remember this distinction:

• Explicit costs are things you paid money for
• Opportunity costs are how much you’d value your best alternative
• Total costs are the sum of explicit and opportunity costs.