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Cost-Benefit Analysis

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Cost-Benefit Analysis

So, you have a $1000 bucks; you want the latest iPhone and the latest PlayStation console. You then realize that you're not rich enough to afford both! Are you buying the phone or the video game console? What do you get if you choose one and leave the other? If you buy the phone, your money is gone, and your ability to own the newest PlayStation console is gone. These are the costs you have to pay, and whatever enjoyment you get from the iPhone is the benefit. This decision-making process is a cost-benefit analysis. Read on, and let's look at the economics involved!

Cost-Benefit Analysis Definition

Let's begin! Whenever a decision is made to purchase something, ordinary people look at how much they will have to spend out of their pockets, which is their cost. They also look at what value they get from the item purchased, which is their benefit. By doing this, they have performed a cost-benefit analysis. Cost-benefit analysis is simply comparing the benefits and costs of a decision.

Cost-benefit analysis is the process of comparing the total costs and benefits of a decision.

Ordinary people look at how much money they have to spend to purchase something, but that is not how we roll as economists. We look at everything else we miss out on as we make the purchase. If buying an NBA ticket means you can't attend that NFL game you've wanted to attend, this cost is the price of the NBA ticket and the value of attending an NFL game.

All these costs combined make up your opportunity cost.

Opportunity cost is the cost incurred by making a choice over other alternatives.

Opportunity cost is the monetary cost (explicit cost) and every other thing (implicit cost) you had to give up to get the product.

Explicit cost refers to an outright payment of money.

Implicit cost is the benefit lost by forgoing an alternative choice.

From what we know so far, we can arrive at how to calculate opportunity cost using this formula:

Look at the following example for opportunity cost.

In one 8-hour work day, a craftsman can make four pots and four vases. However, if he increases the number of pots to 8, he will have to make four fewer vases (in other words, no vases). This means that the opportunity cost of making eight pots is the four vases not made.

In the example above, the craftsman has to spend on making the eight pots directly is 8 hours. On the other hand, by forgoing the vases, they become an implicit cost! These two costs combined represent opportunity costs.

Importance of Cost-Benefit Analysis

Why is cost-benefit analysis important? Because economists want to maximize their benefits. When you make a choice, you want to benefit as much as possible! The total benefits enjoyed by consumers are referred to as "utility." On the other hand, the total benefits for firms are called total revenue. Therefore, consumers compare their costs to their utility, whereas firms compare their costs to their revenue.

If you wanted an NFL ticket and an NBA ticket equally, but you would get leftover money to buy popcorn by choosing the NFL ticket, would you not want to choose the NFL ticket instead of the NBA ticket?

This is the importance of cost-benefit analysis. It informs you about the best choice out of the alternatives available to you.

Cost-benefit analysis provides information on the best choice out of the available alternatives.

Cost-Benefit Analysis Example

In cost-benefit analysis, we look at the benefit and the cost. Economists subtract the total costs from the total benefits to get the total net benefits.

The total net benefit is the difference between the total benefits and the total costs.

Mathematically, this is written as:

As economists are concerned with maximizing their benefits, the choice with which the total net benefit is maximized is referred to as the optimal choice.

The optimal choice for any two alternatives is the choice that gives the highest net benefit.

Now, let's calculate the total net benefit using the example below.

It costs a craftsman $20 in materials to make a pot, and they benefit by gaining $40 from selling it.

From the example, we know the total cost is $20, and the total benefit is $40.

Therefore, we can calculate the total net benefit as follows:

In the example above, the craftsman only had one decision to make. Therefore, there was no need to check the costs and benefits of adding more pots. However, how would things change if he added more pots?

The marginal analysis comes into play here! Marginal analysis is a cost-benefit analysis that considers the cost of an extra unit to the benefit of that extra unit.

Marginal analysis refers to comparing additional costs to additional benefits to one additional unit.

Don't forget the word "additional."

The marginal analysis involves marginal costs and marginal benefits.

Marginal cost refers to the cost of an additional unit of utility. It is the change in total cost.

Marginal benefit refers to the benefit from an additional unit of utility. It is the change in total benefit.

Let's look at an example where marginal analysis can be applied. The table below shows the total costs and total benefits of a craftsman who makes pots. The total cost and total benefit at each stage are indicated.

PotTotal BenefitTotal CostMarginal BenefitMarginal Cost
00000
1405405
26010205
37515155
48520105
5902555

Table 1. ost-benefit Analysis - Marginal Analysis

Marginal benefit is the change in total benefit; therefore, for two pots, that is 60-40=20. The same applies to marginal cost.

Notice how the marginal benefit gets increasingly smaller? This is referred to as the law of diminishing marginal utility.

The law of diminishing marginal utility states that the additional benefit of an added unit of utility increases at a decreasing rate. Therefore, economists will add more utility until the marginal benefit is equal to the marginal cost. his is the optimal choice point

Now, let's plot the total benefit curve! The total benefit is on the vertical axis, whereas the quantity of pots produced is on the horizontal axis. Look at Figure 2.

cost benefit analysis total benefit curve studysmarterFigure 2. Total Benefit Curve, StudySmarter Original

Figure 2 shows that the total benefit for production increases with each added unit. However, the increase in total benefit is not equal to the value of the initial unit (it is less while remaining positive). This is why the curve starts steep and gets flatter with each added unit. It is following the law of diminishing marginal utility!

Now, let's plot the marginal benefit curve! Similar to the total benefit curve, the marginal benefit is on the vertical axis, whereas the quantity of pots produced is on the horizontal axis. Look at Figure 3.

cost benefit analysis marginal benefit curve studysmarterFigure 3. Marginal Benefit Curve, StudySmarter Original

The curve in Figure 3 follows the law of diminishing marginal utility. This is because, at one pot, the marginal benefit is 40. however, the marginal benefit begins to drop slightly with each extra pot added. This can be seen as the slope flattens at two pots (marginal benefit is 20). This goes up to 5 pots, where the marginal benefit is just 5!

Notice how the curve rises then keeps falling? That is the law of diminishing marginal utility visualized!

Cost-Benefit Analysis Formula

When performing a cost-benefit analysis, you want to focus on the total net benefit. The total net benefit is what you are left with once you account for all your costs. The formula is given as follows:

Let's look at the example of the pot craftsman. He makes one pot at $5 and gets a total benefit of $40. When he makes five pots, he spends $25 and gets a total benefit of $90. herefore, his TNB at 1 pot is $40-$5 = $35, whereas his TNB at 5 pots is $90-$25 = $65.

This leads to a dilemma as to maximize their total net benefit per hour; they would only make one pot. However, if they try to maximize their outcome, they would craft five pots.

Steps in Cost-Benefit Analysis

Cost-benefit analysis is a comparison of the benefit and costs of a choice. The cost of a choice involves what you pay (explicit cost) and what you forgo (implicit cost) by making that choice (opportunity cost). This means that in cost-benefit analysis, you should consider the available alternatives that interest you. Here are the steps to follow:

  1. Consider the explicit cost of the choice.

  2. Consider the implicit cost of the choice.

  3. Consider the benefit of the choice.

  4. Subtract both the explicit and implicit costs from the total benefits to get the net total benefit.

  5. Repeat the process for all other alternatives to find the choice with the highest net total benefit (optimal choice).

You made it! You made it through Cost-Benefit Analysis! Our article on Production, Cost, and the Perfect Competition Model will give you a good look at how firms treat costs. You should read it!

Cost-Benefit Analysis - Key Takeaways

  • Cost-benefit analysis is the process of comparing the costs and benefits of a decision.
  • Opportunity cost is the cost incurred by making a choice over other alternatives. It includes explicit and implicit costs.
  • The total net benefit is the difference between the total benefits and the total costs.
  • The choice that gives the highest net benefit is the optimal choice for any two alternatives.
  • Marginal analysis refers to the comparison of additional costs to additional benefits. It is used in cases where a series of decisions can be made to add more units of a utility.

Frequently Asked Questions about Cost-Benefit Analysis

Cost benefit analysis is the process of comparing the costs and benefits of a decision.

Comparing what you would gain from buying an NBA ticket to what you would pay for that ticket is an example of cost-benefit analysis.

Consider the explicit cost of the choice.

Consider the implicit cost of the choice.

Consider the benefit of the choice.

Subtract both the explicit and implicit costs from the total benefits to get the net total benefit.

Repeat the process for all other alternatives to find the choice with the highest net total benefit (optimal choice).

Because it helps you decide which available alternative will give you the highest benefit.

To maximize benefits.

Final Cost-Benefit Analysis Quiz

Question

What is cost-benefit analysis?

Show answer

Answer

Cost benefit analysis is the process of comparing the costs and benefits of a decision.

Show question

Question

What is opportunity cost?

Show answer

Answer

Opportunity cost is the cost incurred by making a choice over other alternatives.

Show question

Question

What is explicit cost?

Show answer

Answer

Explicit cost refers to an outright payment of money.

Show question

Question

What is implicit cost?

Show answer

Answer

Implicit cost is the benefit lost by forgoing an alternative choice. 

Show question

Question

What is total net benefit?

Show answer

Answer

The total net benefit is the difference between the total benefits and the total costs. 

Show question

Question

What is optimal choice?

Show answer

Answer

For any two alternatives, the choice that gives the highest net benefit is the optimal choice.

Show question

Question

What is marginal analysis?

Show answer

Answer

Marginal analysis refers to the comparison of additional costs to additional benefits.

Show question

Question

What is marginal cost?

Show answer

Answer

Marginal cost refers to the cost of an additional unit of utility.

Show question

Question

What is marginal benefit?

Show answer

Answer

Marginal benefit refers to the benefit from an additional unit of utility.

Show question

Question

Total benefit is the same as net total benefit

Show answer

Answer

False

Show question

Question

The total benefit curve slopes the same way as the marginal benefit curve.

Show answer

Answer

False

Show question

Question

The law of diminishing marginal utility states that the additional benefit of an added unit of utility increases at a decreasing rate.

Show answer

Answer

True

Show question

Question

Economists consider opportunity costs and not just explicit costs.

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Answer

True

Show question

Question

What is the formula for total net benefit?

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Answer

Total net benefit = total benefits - total costs

Show question

Question

What is the formula for opportunity cost?

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Answer

Opportunity Cost = Explicit Cost + Implicit Cost

Show question

Question

A baker can bake 20 loaves of sourdough bread and 10 loaves of whole wheat bread in one day. If customers begin asking for 5 more sourdough loaves, he has to make 5 fewer whole wheat loaves. What is the explicit, implicit, and opportunity cost the baker has to consider?

Show answer

Answer

The explicit cost: 25 loaves of sourdough and 5 loaves of whole wheat bread.

The implicit cost: 5 loaves of whole wheat bread he does not bake.

The opportunity cost: 5 loaves of whole wheat bread he does not have to sell.

Show question

Question

Ron can dye his old sweatshirt dark green or light blue. He only has enough money for 1 box of dye. If he dyes it dark green he can still wear it to school, not if it is blue. 

Ron has to compare the costs to his _______.

Show answer

Answer

Utility.

Show question

Question

Bart spends $15 on fertilizer for his pumpkin so that he can win the $100 prize for the largest pumpkin at the fair. What is Bart's total net benefit?

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Answer

$85

Show question

Question

Maggie earned $60 for creating a painting. It cost Maggie $5 for the canvas and $2.50 in paint. What was her total benefit?

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Answer

$60

Show question

Question

Bob's Pressure Washing charges $3 per square foot of surface. The driveway is 25x12 feet. It costs Bob $120 in gas, wages, and materials to get the job done. What is his total net benefit?

Show answer

Answer

$780

Show question

Question

Dr. Frankenstein wants to create another Monster. This will cost him $100,000. if he spends that much on one Monster, he won't have money or time to do any other experiments. What are the explicit, implicit, and opportunity cost?

Show answer

Answer

Explicit cost: $100,000

Implicit cost: knowledge gained from other experiments.

Opportunity cost: The other experiments.

Show question

Question

HatsABCD
00000
1405405
26010205
37515155
48520105
5902555

What does column A show?


Show answer

Answer

Total benefit

Show question

Question

HatsABCD
00000
1405405
26010205
37515155
48520105
5902555

What does column C show?

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Answer

Marginal benefit

Show question

Question

HatsABCD
00000
1405405
26010205
37515155
48520105
5902555

What does column B show?


Show answer

Answer

Total cost.

Show question

Question

HatsABCD
00000
1405405
26010205
37515155
48520105
5902555

What does column D show?


Show answer

Answer

Marginal cost

Show question

Question

You own a business. Once you've paid for your employees, your materials, and your bills, what are you left with?

Show answer

Answer

Your total net benefit.

Show question

Question

When making a choice you should go with the one that offers you the highest total benefit.

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Answer

False. you should go with the one that offers you the highest total net benefit.

Show question

Question

The total net benefit of cleaning a house is $75. The total net benefit of cleaning a garage is $65. Cleaning a house is the ___________.

Show answer

Answer

Optimal choice.

Show question

Question

A company's total revenue is the same thing as an individuals...

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Answer

Utility.

Show question

Question

The quantity of goods is always on the Y axis.

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Answer

False, it is on the X axis.

Show question

Question

The increase in total benefit is not equal to the value of the initial unit. 

Show answer

Answer

True.

Show question

Question

Why do implicit costs matter?

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Answer

It helps us figure out the opportunity cost of the choices we make what we are forgoing.

Show question

Question

What tool can a company use to make sure it maximizes its benefits?

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Answer

Cost-benefit analysis

Show question

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