Question

Suppose jill Johnson operates her pizza restaurant in a building she owns in the center of the city. Similar buildings in the neighborhood rent for \(\$ 4,000\) per month. Jill is considering selling her building and renting space in the suburbs for \(\$ 3,000\) per month, but she decides not to make the move. She reasons: "I would like to have a restaurant in the suburbs, but I pay no rent for my restaurant now, and 1 don't want to see my costs rise by \(\$ 3,000\) per month." Evaluate jill's reasoning.

Short answer

Jill's reasoning is incorrect as she did not account for the opportunity cost. By moving to the suburbs and renting her own building, she could actually reduce her overall costs.

Step-by-step solution

Identifying explicit costs and benefits

Firstly, evaluate the explicit costs and benefits of the decision. Moving to the suburbs would incur Jill a rent of $3,000 per month.

Identify opportunity costs

Find out the opportunity cost of staying in the city center. If Jill were to rent out her own building, she could earn $4,000 per month. This is an opportunity forgone and forms an implicit cost for the decision to stay.

Compare the sum of explicit and implicit costs

The explicit costs of moving to the suburbs for Jill are indeed $3,000 which she would have to pay as rent. But, her implicit costs or opportunity costs of staying in the city center are higher, which are $4,000. This is because she could have rented out her own building and earned this amount.

Make a decision

Taking into account both explicit and implicit costs, it is more cost effective for Jill to move to the suburbs and rent her city center building. Her reasoning was flawed because it did not take into account the opportunity cost.

Key concepts

Implicit Costs

Implicit costs are often hidden, but they play a crucial role in decision making. These costs are not directly paid out in cash, but represent potential income that is lost when a particular decision is made. In Jill's case, she owns a building in the city center that she could rent out for $4,000 per month if she decided to move her restaurant.
This $4,000 per month is an implicit cost of staying in her current location since it's income she is missing out on. Understanding implicit costs helps in recognizing the true value of resources that are already owned.
They remind us that not all costs show up on a financial statement. By considering these costs, individuals and businesses can make more informed financial decisions.

Explicit Costs

Explicit costs are straightforward and involve direct payments. These are easy to identify and quantify as they are tangible expenditures. In the scenario of Jill and her restaurant, if she decided to relocate to the suburbs, her explicit cost would be the $3,000 per month in rent she would need to pay for the new space.
Unlike implicit costs, explicit costs are clear and recorded in financial documents, making them easy to track. They are essential in calculating the actual out-of-pocket expenses associated with a decision.
By comparing explicit costs across different choices, businesses can evaluate which option requires less upfront expenditure.

Decision Making in Economics

Decision making in economics involves weighing all costs and benefits to make the most financially sound choice. It requires looking beyond just immediate expenses and considering both explicit and implicit costs. Jill's decision-making process should include an evaluation of the $3,000 explicit rent cost in the suburbs against the $4,000 implicit cost of income forgone by not renting out her city building.
Effective decision making requires a comprehensive analysis of these costs to determine the best financial route. By missing the implicit costs in her reasoning, Jill misjudged the financial impact of staying versus moving.

• Evaluating all costs ensures a more complete understanding of the economic implications.
• Failing to consider opportunity costs, like implicit ones, may lead to suboptimal decisions.

Recognizing both types of costs is key to sound economic decisions.