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Lesson 03 Key Economic Concepts
Resource Management Framework
Resource management is a challenging task. The task is made somewhat easier, however, if one has some basic frameworks that can be used to make sense of the situation. The goal of Lesson 3, is to provide some of those frameworks.
If a decision is being considered within a higher education institution, these frameworks can help one identify important considerations related to that decision. These frames can also help identify what data are needed to help further the discussions that are needed in order to come to a decision.
Within economics, the principle of benefit-cost analysis is often promoted. The idea is that if you're facing a decision-- in other words, you're thinking about whether or not to adopt a particular new policy-- you should try to state the benefits and the costs associated with this new policy. And optimally, measuring the benefits and costs and then quantifying them, and comparing them. But even if you can't measure them, at least being able to clearly state what are the benefits and the costs, so you can sort of talk through them.
It's sometimes tricky to figure out what should be included as a cost, or not. Often, people include things in the cost category that shouldn't be included. And sometimes, they fail to include things that should be included.
And there are some concepts from economics that are helpful in trying to think about what should be included that cost category. We'll go over four of those concepts: variable versus fixed, average versus marginal, and opportunity and sunk costs.
Variable vs Fixed Costs
The first set of concepts is going to, in many ways, lay the groundwork for the next three. This first set focuses on variable versus fixed costs. Included below are some of the textbook definitions of the two.
- Variable costs - costs that do vary with the quantity of output produced.
- Fixed costs - costs that do not vary with the quantity of output produced.
If you think about a college or university contemplating expanding enrollment, well, there are certain costs that will increase with this increased enrollment. If you increase enrollment enough, you may need to offer more classes which means you're going to need individuals to teach those classes. The additional instructor needs to be associated with the cost. It could also require an expansion of certain services at the institution. All of these factors would be a variable cost. There are some fixed costs with this example. Certainly, aspects of the library may not need to change. You would not need to expand the library to enroll more students. You may also not have to change the basic administrative structure of the institution. And so, a lot of those costs are fixed and will not increase with enrollment.
Using this as a basic example, you can see why this is an important distinction when you're thinking about a decision. Because fixed costs are things that you probably don't need to pay a lot of attention to, because they're going to be the same regardless of whether you say yes or no to the proposal on the table.
Now, a key point-- is something variable or is something fixed? Because often it really is a nuanced question. And one of the major parts of that nuance is the time frame being analyzed.
Let's say you're thinking about closing a program, and the leadership of the institution is trying to understand how much money will be saved as a result of the program closure. Well, it really depends upon the time frame. You think of the next two years-- you may not save that much if a lot of the faculty in the program are tenured. Or, a lot of the personnel in the program are on five-year contracts, then you're probably not going to save a lot of money in the short run. But, if you think 20 or 30 years down the line, or maybe even six years down the line, depending on the time horizon of the people working in that unit. Then, all of a sudden, the costs will vary with whether or not that program is eliminated. There's some nuance here, so you have to sometimes put your thinking cap on to really distinguish whether something's variable or fixed.
Average vs. Marginal Costs
The variable-fixed distinction is very helpful, because it makes it easier for one to understand the concept of a marginal cost. To talk about that concept, let me provide the textbook definition of marginal cost next to the definition of average cost.
- The average cost is simply the total cost divided by the quantity of output. So you could estimate the total amount of cost, then divide it by the number of students. Or, the total cost divided by the number of programs at an institution.
- The marginal cost is saying, if we decide to expand what we're doing-- either growing enrollment, or adding a new program, or putting in a new policy-- what would be the change in our costs that is driven by this new policy, this new approach?
This is really what we're going to care about whenever we're trying to help support decision-making. If you want to understand the economic consequences of a decision, you want to compare marginal cost and marginal revenue. If we do this, these are going to be the change in our costs-- that's the marginal costs. And this is going to be the change in our revenues, the marginal revenue. One of the key points made in economics is that you want to be thinking about things on the margin-- what's the marginal cost, what's the marginal revenue.
If you're trying to support decision-making through data, it's much easier to estimate the average cost than it is the marginal cost. Because the average cost, you can simply say, here's what's going on now and let me just take data for right now, and let's compute the average cost with those data. Marginal cost is much trickier because it's more saying this is what's going to happen if we put this policy in place. And until we build a time machine for the future, we're not going to be able to go to the future, obtain the data of what happens when you put this policy in place, and then come back and produce the estimate of the marginal cost. We have to try to produce a sound estimate of what will be the change in cost, due to this new policy.
Opportunity and Sunk Costs
Now, the next two cost concepts are going to be fun, because they're both helpful in two types of venues. The first venue is the context associated with this course-- making decisions within a college or university. The second venue is one's day-to-day personal life. And I'll touch upon that for each of these concepts, after going over the use of these concepts within the college or university decision-making process.
Brinkman states that the fundamental meaning of cost is always to be found in foregone opportunities. The logic underlying his statement is related to this idea of opportunity cost, which is whatever must be given up to obtain some item. Most of the time, when we think about if we're going to obtain something, whether it's a new policy, a new program, stronger students at your institution in terms of their academic preparation. When we think about what will it cost to do this, certain things immediately come to mind. But there are other important costs that won't come to mind as much. And the nice thing about opportunity cost, and structuring it in as whatever must be given up to obtain something-- using that framework will help us to identify some things that won't be as prominent in our minds.
So let's give a couple examples and run through those.
People think about, well how much does college cost? They immediately think of, well, there's tuition, and fees, and room and board. But when you really think about costs, in terms of the sort of costs you want to include in benefit-cost analysis. You start saying, OK well, tuition and fees are relevant, but room and board is only somewhat relevant, because you're still going to need to eat, even if one was not going to attend college. So you really have this important thing about what's actually given up to obtain this college education.
How much more are you going to have to spend on room and board by attending college, that you wouldn't otherwise? So you'd think about what must be given up and then something comes to mind which people don't think of immediately. Full-time employment. For those individuals who would have the option of working a full-time job, attendance at college would preclude their full-time employment in that job. This represents a major cost of attending college full-time, foregoing earnings associated with employment. This cost typically does not come to people's mind when initially considering this example. What comes to people's mind is tuition and fees, which again is the benefit of thinking through costs in this manner.
So now let's think about a decision or policy under consideration within a college or university. A lot of these times, you're going to think about personnel costs. What's the cost in terms of personnel of this new policy activity? This is a very easy activity when you're thinking about hiring-- you're thinking about something that would require you to hire someone new. When you think about, OK, we'd have to hire this many positions, and the cost associated with this position is this much, then it's easier to estimate those costs.
But it's much trickier when you're thinking about making a decision, or putting in a policy that would cause people who are already working at your institution to have to do more things as a result of your decision. Because in many cases, unless there's a lot of slack in your organization, these individuals will do less of other activities in order to do these new activities. Or, maybe they'll still do those old activities, they just won't do them as well. And you can't put a dollar sign, easily, to these foregone activities as a result of this new policy. And so this is where you have to think about, well, what are these costs? How do we make sense of them in the decision-making process?
Now, let's talk about how to apply opportunity cost to one's day-to-day life. Because as I promised you, these concepts are also helpful in that venue. Here is a personal example.
Imagine you are busy, working in a full-time job that requires a lot of energy. Imagine that you are also married with two small children, who you enjoy spending time with. Between work and family responsiblities there is only a few opportunities for discretionary time. So what do you do with that time? Do you browse the internet at your office? Do you run errands? Do you go home? What should drive this decision is do you derive a sense of enjoyment from the activity? Do you like it? Is there something that you would miss out on if you complete one activity as opposed to another? Because when discretionary time is scarce, if you do something you kind of like, the cost of that is something you may really like. A certain level of discipline, and making sure that you're spending your discretionary time on those things you most value becomes quite important.
But I've always enjoyed opportunity and sunk cost because not only are they helpful in the day-to-day professional life, but they're really often helpful guides in other venues as well.
Now, the concept of sunk cost is the opposite, in ways, of the concept of opportunity cost. Let me explain what I mean by that. The opportunity cost idea is typically helpful because it helps you identify things that should be included as an important cost associated with the decision, but which you wouldn't include if you relied upon the normal thought process of a human being.
Sunk cost, in contrast, helps you identify those costs that you would include if you used the normal thought process, but in reality shouldn't be included in the decision making process. Consider the following definition.
- Sunk cost - a cost that has already been committed and cannot be recovered.
Because a sunk cost cannot be recovered, it won't be influenced by what decision you make. It should be ignored in the decision-making process.
Let me give a couple of examples. One from the perspective of working within a college or university, the other from the perspective of one's day-to-day life.
Let's say that you have invested a lot of money in a new data storage system. So there was a rather large upfront investment to institute this new system. After that initial upfront investment there are maintenance cost year-to-year. Those costs, however, are not as large as the upfront cost. The thought process we're going to go to can apply to anything that can be implemented at a college or university in which there is an upfront cost and then a lesser maintenance cost over time. And so you now have this decision. Let's say three years after you institute the data storage system, you must decide whether or not you want to continue to use it, or replace it with a new one.
When you're making that decision, you have to think about, how much would I benefit from this switch? Let's say you put in the data storage system and you're really not happy with it. Really, the functionality associated with it isn't that great. And so you're thinking about, the benefits could be kind of substantial if I were to make a switch.
But then what are the costs? Well, it would be the cost of instituting this new system versus any future maintenance cost differentials between the new system and the one you currently have. So notice what was not in that list of benefits and costs. What was not in that list is, how much it originally cost to put in your current data storage system.
But the human brain seems to almost be hardwired to want to include that in the cost comparison.
And if you don't believe me, consider the following example from day-to-day life.
Imagine you are attending some sort of event with an intermission. Let's say you're attending a theater, watching a play, but really it could be anything. You could be attending a sporting event or a concert. Something where you attend, watch half the performance, have an intermission, and then go in and watch the second half of the performance. Now imagine you attend the first half, and you're just not enjoying it. You're bored or perhaps bothered about something related to the performance.
You know intermission is coming and so you've reached the point of making the decision... Do you stay or do you go? And really, if you think about this benefit-cost analysis, you should be thinking about the costs and benfits that will be influenced by this decision. One obvious benefit might be that you could spend your remaining time doing something that you would enjoy more. The cost will be missing out on seeing the second half of this performance.
Now imagine that you paid a fair amount of money for the ticket to the performance. How would this change your decision making? We are naturally more inclined to stay for the second half of the performance if we paid a lot of money for the ticket as opposed to if we got it cheaply, won it, or it was given to us.
It's hard, even with the understanding sunk cost intellectually, to let go of our emotion and recognize that it is irrelevant to the decision-making process. And that's why, again, these concepts are so helpful-- they help us, help guide our decision making in ways that our mind would not normally work.
So we've gone over a number of concepts now. It makes sense to talk a little bit about application. And so let's just summarize the concepts. When we're examining a potential decision, we should compare marginal revenues with marginal costs. That is, we should compare benefits and costs. And, when thinking about, what are the benefits and what are the costs, we should think about what is going to be altered by this particular decision.
When we think up our list of costs, we want to include all relevant costs. And the concept of opportunity cost helps us identify things that are foregone, that we wouldn't normally think of. We don't want to include things that are not relevant, that are not associated with this decision. So the concepts of sunk cost or fixed cost can help us do that.