1. 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.

2. 3-2 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.

3. 3-3 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 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

4. 3-4 Opportunity Cost Cost associated with forgoing the opportunity to employ a resource in its best alternative use Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

5. 3-5 Maximizing Benefits Less Costs – Example Your car is worth more as a mechanic spends more time repairing it Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

6. 3-6 Maximizing Benefits Less Costs – Example Out-of-pocket costs Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

7. 3-7 Maximizing Benefits Less Costs – Example Opportunity cost: you forgo the opportunity to use your car to deliver pizzas Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8. 3-8 Maximizing Benefits Less Costs – Example Best choice Total benefit less total cost Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9. 3-9 Maximizing Benefits Less Costs – Example Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

10. 3-10 Maximizing Net Benefits 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.

11. 3-11 Maximizing Net Benefits – “Total” Approach Maximize net benefit (total benefit – total cost) Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

12. 3-12 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 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

13. 3-13 Total Cost and Marginal Cost Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

14. 3-14 Total Benefit and Marginal Benefit Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

15. 3-15 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 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

16. 3-16 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.

17. 3-17 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.

18. 3-18 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.

19. 3-19 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.

20. 3-20 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. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

21. 3-21 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 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

22. 3-22 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 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

23. 3-23 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 Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

24. 3-24 Constrained Optimization Example Car Repair B E (H E ): total benefit of doing H E hours of engine work B B (H B ): total benefit of doing H B hours of body work Your budget allows you to afford 10 hours of repair work Constrained optimization problem – Choose H E and H B to maximize B E (H E ) + B B (H B ) – Subject to the constraint that H E + H B = 10 Solving by the substitution method – From the constraint: H B = 10 - H E – Substituting into the objective function: choose H E to maximize B E (H E ) + B B (10 - H E ) Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

25. 3-25 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) Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

26. 3-26 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.