Balancing Benefits
and Costs
chapter 3
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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
Total benefit
less total cost
Best
choice
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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
Best choice
MC
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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.
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Total Benefit and Marginal Benefit
with Finely Divisible Actions
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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.
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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.
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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 Example
Car 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
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