Conceptual Tools

Opportunity Cost

The next best alternative that is given up while making a decision or choice.
Example: If I spend $10 buying a coffee, what are the other options that I could get other coffee? The opportunity cost of buying the coffee at a cafe could be a Donut or Hot Chocolate

Sunk Cost

Costs that are incurred and cannot be recovered.

Sunk Cost Fallacy – Continuing an action that negatively affects you because you feel you need to "make your money’s worth."

Movie Example

• S pays for a ticket but realizes 30 minutes in that the movie is bad.
• If S stays, it won’t recover the cost or improve the experience.
• If S leaves, they avoid wasting time.
• But S decides to stay because they "paid for it" → Sunk Cost Fallacy.

Car Example

• If S is traveling to Goa:

  • Bus ticket: ₹1500.
  • Car costs: Higher, but Insurance and Interest are Sunk Costs (already paid and cannot be recovered).

  

  • According to these calculations, taking the car costs more. BUT Insurance and Interest are SUNK COSTS. Insurance and Interest are already paid and cannot be recovered by not driving the car, hence should be ignored.

  

Marginal Principle:

Deals with "per additional unit" – revenue, cost, or profit for each additional unit of activity.

Key Formulas

• Net Benefit = Total Benefit - Total Cost
• Profit = Revenue - Costs
• Total benefit increases if Marginal Benefit > Marginal Cost.

Example: Rahul’s Bookstore Expansion

Rahul owns 3 bookstores and is considering opening a 4th.

• He creates the following table, which shows him the average benefit is still greater than average

• However, by performing manual profit calculations (Total Revenue – Total Cost), we can see that if Rahul opens a 4th store, his profit goes down from 2.1L to 1.6l, a loss of 50,000

• In this case, we can use Marginal Benefit instead of Average benefit to calculate the actual profit Rahul would have. We calculate marginal be subtracting the previous total and keeping only the value that corresponds to No of bookstores. (Ex. For the third bookstore, the total revenue (5,10,000) subtracted by the previous total (3,60,000) will give us the marginal revenue (1,50,000)). By doing this as well, we can see that the marginal profit going from 50,000 to -50,000.