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Opportunity cost
The most important concept in analyzing decision making is opportunity cost.
For a decision maker, the opportunity cost of doing
A
A
exceeds its opportunity
cost, then the decision maker should do
A
. Otherwise, the decision maker should
not do
A
.
The
next best thing
depends on what
A
is and what else is feasible. Often,
doing that is easy to calculate.
2
3 kinds of decisions
1. Unconstrained continuous choice.
2. Constrained continuous choice.
3
Unconstrained continuous choice
This is the simplest kind of optimization problem. The decision maker has to
choose how much of a quantity to produce or consume. For example:
A monopolist wants to choose how much output to produce and sell.
A driver has to decide how fast she wants to drive on the highway.
Jill wants to decide how late to stay out at a party when she has to go to
class the next day.
Jill has to decide how long to surf the web in the evening when she has to
go to class the next day.
Jack has to decide how much food to eat at a bu/et.
4
Jill goes to the party. Let
t
be the amount of time she wants to stay at the
B
(
t
)
. We assume that
B
(
:
)
is increasing in
t
at a decreasing rate. Look at the picture:
Because
B
(
t
)
is increasing in
t
, the slope of
B
(
t
)
with respect to
t
or marginal
t
is:
MB
(
t
) =
@B
@t
>
0
1
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t
increase in
t
. Because
B
(
t
)
is increasing at a decreasing rate, the slope of the
@MB
(
t
)
@t
=
@
2
B
dt
2
<
0
A simple parameterization of
B
(
t
)
is a quadratic function:
B
(
t
)
=
b
0
+
b
1
t
b
2
2
t
2
;
b
1
;b
2
>
0
MB
(
t
)
=
@B
@t
=
b
1
b
2
t >
0
@MB
(
t
)
@t
=
@
2
B
dt
2
=
b
2
<
0
Note that for
t
large enough,
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This note was uploaded on 11/10/2010 for the course ECO ECO200 taught by Professor Carlosserrano during the Fall '10 term at University of Toronto Toronto.
 Fall '10
 CarlosSerrano
 Microeconomics, Opportunity Cost

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