The importance of marginalism Costs and Benefits The importance of marginalism

Maximizing net benefit Slogans: “Greatest good of the greatest number” “Do it if the benefits outweigh the costs” “Maximize benefits and minimize costs” Are imprecise guides to economic decisions whose goal is to maximize economic surplus or net benefit.

Comparing costs and benefits Net benefit = Total Benefits - Total Costs To maximize NET benefits, find the level of an activity at which MARGINAL COSTS = MARGINAL BENEFITS (or as close to equality as the problem permits)

MC = MB leads to UNIQUE solution Marginal costs = marginal benefits will lead to the unique optimal decision. Total Benefit > Total Cost will NOT lead to a unique solution. Since both benefits and costs will normally rise with the level of an activity, many possible levels have total benefits greater than total costs. But since marginal costs normally rise and marginal benefits normal decline, there will be one level of an activity at which MC = MB.

MC = MB is easy to apply Marginal costs = marginal benefits can be applied more easily than any other rule. Maximizing Total Benefit - Total Cost by exhaustive calculation requires knowing all the costs and benefits before taking any decision. Outside of textbooks, we rarely know this. The equimarginal principle can be applied in stages: if MB > MC at a given level of activity, increase the activity; if MB < MC, decrease the activity; if MB = MC, stop.

Umbrellas and utility http://www.geocities.com/oldiesgg/singingin.mid Click above for the title song

Example: how many umbrellas Example: how many umbrellas? (umbrellas cost $5 each; declining marginal benefit) Umbrellas Tot.Benefit Tot.Cost Surplus 1 40 5 2 60 10 3 75 15 4 85 20 90 25 6 93 30

Total benefits and costs -- graphically 100 80 60 40 20 Umbrellas 1 2 3 4 5

Total benefits – diminishing marginal returns 100 80 60 40 20 Umbrellas 1 2 3 4 5

Total costs in blue -- $ 5 per umbrella Benefits and Costs Note that total benefits are ALWAYS greater than total costs. 100 80 60 40 20 Total costs rise linearly with quantity – 5 umbrellas cost $ 25 Umbrellas 1 2 3 4 5

Example: how many umbrellas Example: how many umbrellas? (direct computation eventually leads to the answer: you maximize surplus with 4 or 5 umbrellas ) Umbrellas Tot.Benefit Tot.Cost Surplus 1 40 5 35 2 60 10 50 3 75 15 4 85 20 65 90 25 65 ** 6 93 30 63

Example: how many umbrellas Example: how many umbrellas? (computing MARGINAL BENEFIT leads to the same answer as computing all net benefits) Umbrellas Tot.Benefit M.Benefit MB ?? MC ----- ---- 1 40 MB > MC 2 60 20 3 75 15 4 85 10 5 90 MB = MC ** 6 93 MB < MC

MARGINAL = ADDITIONAL In the last table, MARGINAL BENEFIT was computed as the difference between the benefit resulting from an additional umbrella and the benefit without the additional umbrella. For example, MB at 4 umbrellas is equal to Total Benefit at 4 minus Total Benefit at 3 or 85 – 75 = 10.

Marginal benefits and costs -- graphically 40 35 30 25 20 15 10 5 MB = MC Marginal cost = $ 5 Umbrellas 1 2 3 4 5

Advantages of marginalism Step-by-step procedure: even if we did not know all the costs and benefits, we can take another step (increase the level of activity) as long as MB > MC. “How much would you be willing to pay for 5 umbrellas?” is a hard question to answer; “How much would you pay for another umbrella?” is an easier question to answer. Faster “what-if?” recalculations. What if the price of umbrellas were $8? $15? Using the “total benefit” method requires every calculation to be repeated; but we could read the result quickly from the marginal table.

Tomatoes and Diminishing Marginal Returns

Example: how much compost Example: how much compost ? (cost of compost 50 cents per pound; price of tomatoes 30 cents per pound) Compost Tomatoes M.Product MB = Price times MP 100 ---------- 1 120 20 $ 6.00 2 125 5 $ 1.50 3 128 $ 0.90 4 130 $ 0.60 131 $ 0.30 6 131.5 0.5 $ 0.15

Tomatoes and compost What if the price of compost rises to $ 1.00 a pound? (answer: buy 2 pounds) What if the price of tomatoes rises to 60 cents a pound (with compost at 50 cents)? Multiply marginal product by $0.60 to get a new “marginal benefit” column; compare to the price of compost. Compute the net benefit in the original case and the above two problems to satisfy yourself that the MB = MC rule will maximize net benefit in all cases.

Example: how much compost Example: how much compost ? (cost of compost 50 cents per pound; price of tomatoes $ 0.60 per pound) Compost Tomatoes M.Product MB = Price times MP 100 ---------- 1 120 20 $ 12.00 2 125 5 $ 3.00 3 128 $ 1.80 4 130 $ 1.20 131 $ 0.60 6 131.5 0.5 $ 0.30

Marginal benefits and costs -- graphically 3.00 2.00 1.00 0.50 MB = MC at between 5 and 6 pounds of compost Marginal cost = 50 cents 1 2 3 4 5 Fertilizer