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chapter 3
Balancing Benefits and Costs
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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Learning Objectives
• Understand the concept of maximizing benefits less costs.
• Describe what it means to think on the margin.• Explain the concepts of marginal benefit and
marginal cost.• Use marginal analysis to identify best choices.• Understand why sunk costs can be ignored in
making economic decisions.
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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Overview
• Common thread: rational decision making• Good economic decisions maximize benefits
less costs• Economists frequently think on the margin• Decision makers should ignore sunk costs• We often face constraints – constrained
optimization
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Opportunity Cost
• Cost associated with forgoing the opportunity to employ a resource in its best alternative use
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Maximizing Benefits Less Costs – Example
Your car is worth more as a mechanic spends more time repairing it
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Maximizing Benefits Less Costs – Example
Out-of-pocket costs
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Maximizing Benefits Less Costs – Example
Opportunity cost: you forgo the opportunity to use your car to deliver pizzas
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Maximizing Benefits Less Costs – Example
Best choice
Total benefit less total cost
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Maximizing Benefits Less Costs – Example
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Maximizing Net Benefits with Finely Divisible Actions
•
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Maximizing Net Benefits – “Total” Approach
• Maximize net benefit (total benefit – total cost)
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Maximizing Net Benefits – Marginal Approach
• Marginal cost: additional cost incurred because of the last ∆H hours of repair time
• Marginal benefit: extra benefit from the last ∆H hours
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Total Cost and Marginal Cost
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Total Benefit and Marginal Benefit
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Maximizing Net Benefits – Marginal Approach
• No marginal improvement principle: at a best choice, the MB of the last unit must be at least as large as its MC, and the MB of the next unit must be no greater than its MC
Best choice
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Total Benefit and Marginal Benefit with Finely Divisible Actions
• When actions are finely divisible, the marginal benefit when choosing action X equals the slope of the total benefit curve at X.
• Note that in this example the marginal benefit decreases when the number of hours increases.
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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Total Benefit and Marginal Benefit with Finely Divisible Actions
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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Total Cost and Marginal Cost with Finely Divisible Actions
• When actions are finely divisible, the marginal cost when choosing action X equals the slope of the total cost curve at X.
• Note that in this example the marginal cost increases when the number of hours increases.
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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Total Cost and Marginal Cost with Finely Divisible Actions
• When actions are finely divisible, the marginal cost when choosing action X equals the slope of the total cost curve at X.
• Note that in this example the marginal cost increases when the number of hours increases.
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
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Best Choices and Marginal Analysis with Finely Divisible Actions
• No marginal improvement principle (for finely divisible actions): marginal benefit equals marginal cost (MB = MC) at any best choice.
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Marginal Approach vs. “Total” Approach
• At the best choice, the tangents to the total benefit and cost curves have the same slope and are therefore parallel.
• MB = MC
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Sunk Costs and Decision Making
• A sunk cost is a cost that the decision maker has already incurred, or to which she has previously committed. It is unavoidable.
• The level of sunk costs has no effect on the best choice.
Curve with higher sunk cost
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Constrained Optimization
• A constrained optimization problem involves choosing the levels of some variables to maximize the value of an objective function subject to satisfying certain constraints
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Constrained Optimization ExampleCar Repair
• BE(HE): total benefit of doing HE hours of engine work• BB(HB): total benefit of doing HB hours of body work• Your budget allows you to afford 10 hours of repair
work• Constrained optimization problem– Choose HE and HB to maximize BE(HE) + BB(HB)– Subject to the constraint that HE + HB = 10
• Solving by the substitution method– From the constraint: HB = 10 - HE
– Substituting into the objective function: choose HE to maximize BE(HE) + BB(10 - HE)
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Review
• A best choice yields the highest net benefit of all alternatives
• The no marginal improvement principle says that if an action is a best choice, then a small increase or decrease in the activity level cannot increase net benefit– For finely divisible actions, marginal benefit = marginal cost at
the best choice• Sunk costs should have no effect on a best choice• In many economic problems the decision maker faces a
constraint that requires making tradeoffs to reach the best choice (constrained optimization)
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Looking forward
• Both consumers and firms strive to make optimal choices
• In the next few chapters we will learn about consumer preferences and budget constraints, how they shape consumer decisions, ultimately represented in the demand curve
• Next, we will focus on representing consumer preferences with indifference curves and utility functions
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
