Relevant Costs 229obtain it. The fact of ownership doesn’t change this cost; opportunity cost is still
determined by the market price.^2
The concept of opportunity cost is simply another way of comparing pros
and cons. The basic rule for optimal decision making is this:Undertake a given course of action if and only if its incremental benefits exceed its
incremental costs (including opportunity costs).Thus, pursuing the MBA degree makes sense only if the associated benefits—
acquisition of knowledge, career advancement, higher earnings—exceed the
total costs. Likewise, the factory space should be used only if the direct increase
in cash flows exceeds the opportunity cost. Finally, the garage should be built
only if its total benefits exceed its costs.(^2) Of course, explicit costs and opportunity costs sometimes differ. For example, suppose an indi-
vidual possesses financial wealth that earns an 8 percent rate of return. If that person were to bor-
row from a bank, the rate would be no lower than 11 percent. Then the opportunity cost of
internally financing payment of MBA tuition is lower than the market cost of obtaining a loan to
do so.
CHECK
STATION 1
How would one estimate the full cost to an airline if one of its planes is held over for
24 hours in a western airport for repair?
ECONOMIC PROFIT At a general level, the notion of profit would appear
unambiguous: Profit is the difference between revenues and costs. On closer
examination, however, one must be careful to distinguish between two defini-
tions of profit. Accounting profitis the difference between revenues obtained
and expenses incurred. The profit figures reported by firms almost always are
based on accounting profits; it is the job of accountants to keep a careful watch
on revenues and explicit expenses. This information is useful for both internal
and external purposes: for managers, shareholders, and the government
(particularly for tax purposes). With respect to managerial decision making,
however, the accounting measure does not present the complete story con-
cerning profitability. In this case, the notion of economic profit is essential.
Economic profit is the difference between revenues and all economic costs
(explicit and implicit), including opportunity costs. In particular, economic
profit involves costs associated with capital and with managerial labor. Here is
a simple illustration.
STARTING A BUSINESS After working five years at her current firm, a money
manager decides to start her own investment management service. She has
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