16 Chapter 1 Personal Finance: An Overview
saved and on how much money you can comfortably spend. The choice will
be different for different people.
You can use cost-benefit analysis to decide whether or not college is worth its
cost, whether a new car is worth a higher cost than a good used car, or whether
a big wedding is worth its cost compared to the cost of a small, simple wedding.
You simply calculate the cost, put a value on the benefits, and compare the results.
In some situations, you will be weighing dollar costs against social,
psychological, or emotional benefits. A vacation presents pleasure, time with
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and money. Cost-benefit analysis makes these decisions more rational and
well-reasoned.
This principle applies to economic decisions of individual consumers,
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Marginal Analysis
Marginal analysis is also a powerful decision-making tool, particularly in
business. It measures the added benefit, versus the added cost, of one more unit of
a product. The change in total benefit of using one additional unit is the marginal
benefit. The change in total cost of using one more unit is the marginal cost.
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you buy another and another. Will the second apple bring as much satisfaction
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be even less satisfying. You would probably be willing to pay more for that first
apple than for the second, more for the second than for the third. Eventually, you
stop eating because you get little or no benefit since your stomach is full.
The marginal benefit of using each additional unit of something tends
to decrease as the quantity used increases. This is called the economic law
of diminishing marginal utility. The law applies to thrill rides, snacks, movie
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business when measuring the cost of increasing production.
Trade-Offs and Opportunity Costs
The choices you make involve trade-offs and opportunity costs. When
you make a choice, you trade off or give up the other choices you could have
made. The trade-off, or what you give up, is the opportunity cost of the choice
you made. When you choose one of two options, the one you did not choose
is the opportunity cost of your choice.
A trade-off is the choice you give up when you make one choice over
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Making a choice results in a trade-off, and a trade-off results in an
opportunity cost. Opportunity cost is the value of the option you gave up. If
you turn down an after-school job because you have to be at soccer practice,
there is an opportunity cost. The opportunity cost of playing soccer is the
after school job and the money you could have earned. The opportunity cost
of working instead of playing soccer would be the pleasure and advantages
you get from playing a team sport you love.
Opportunity cost can be measured in terms of dollars, time, enjoyment,
or something else of value. The opportunity cost of a decision often varies