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Objectives:

To understand and distinguish between the two types of economic decisions: “either-or” decisions and “how much” decisions.

To understand the method of economic decision making: weighing the costs and benefits of any activity before undertaking that activity.

To understand and apply the principle of marginal analysis used in making “how-much” decisions.

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Module 1: Economic Decision Making and Marginal Analysis

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To understand and distinguish between the two types of economic decisions: “either-or” decisions and “how much” decisions.

a. The state government is considering whether to build a public library or a new elementary school.

“either–or” decision

b. Executives at Apple Computer are debating whether or not to produce an additional 300,000 i-Phones this year.

“how-much” decision

c. You have been accepted into the Peace Corp and will be posted to the Czech Republic. You must now decide whether to join the Peace Corp or to go school full time at Arizona State University.

“either–or” decision

d. You are deciding whether to cut back your 30-hour work week to 20 hours so that you can take an evening class at your local college.

“how much” decision

e. The price of tuition at your community college has gone up. You’re considering taking less units.

“how much” decision

Objective 1

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To understand the method of economic decision making: weighing the costs and benefits of any activity before undertaking that activity.

The first step in evaluating an economic activity is to identify the relevant benefits and costs.

For example, if the state government has to decide between building a public library or a new elementary school, it must first evaluate the total costs and total benefits of each project and then allocate funds to the project that yields the highest net benefit.

For either-or decisions, the relevant costs and benefits are the total costs and total benefits.

Objective 2

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For the “how-much” decision, the relevant cost is the marginal or incremental cost and the relevant benefit is the marginal benefit or incremental benefit.

The principle of marginal analysis is used to answer the “how-much” question.

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The margin is defined as “the next step”; it could be an incremental step (a little bit more) or a decremental step

(a little bit less).

To understand and apply the principle of marginal analysis used in making “how-much” decisions.

Objective 3

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Marginal Analysis involves comparing:

the benefit from that next step which is called Marginal Benefit

with

the cost of taking the next step which is called Marginal Cost

In marginal analysis, the relevant cost is the marginal cost and the relevant benefit is the marginal benefit.

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If Marginal Benefit > Marginal Cost The activity yields a Net Marginal Benefit

If Marginal Benefit < Marginal Cost The activity yields a Net Marginal Cost

If Marginal Benefit = Marginal Cost You have reached the optimal quantity

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The Rule of Marginal Analysis

The optimal quantity is the quantity at which:

Marginal Benefit = Marginal Cost or

Marginal Benefit ≥ Marginal Cost

Note:

Marginal Benefit ≠ Total Benefit (except when going from 0 to1)

Marginal Cost ≠ Total Cost (except when going from 0 to1)

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Applying Marginal Analysis

Example 1:

Jerry owns a candy store. The store's revenues depend on the number of hours the store is open each day as shown in the Table below. The cost of staying open each hour is $10. If Jerry follows the marginal principle, how many hours each day should he keep his store open?

HoursOpen

Total Revenue(Total Benefit)

$

0 0

1 25

2 45

3 60

4 70

5 75

6 79

7 81

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HoursOpen

Total Revenue(Total Benefit)

$

MarginalBenefit

(∆ Total Benefit)$

0 0 0

1 25 25

2 45 20

3 60 15

4 70 10

5 75 5

6 79 4

7 81 3

Step 1: Determine what is the marginal benefit?

The marginal benefit is the marginal revenue or incremental revenue.

Solving the problem

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HoursOpen

Total Revenue(Total Benefit)

$

MarginalBenefit

(∆ Total Benefit)$

MarginalCost

$

0 $0 0 0

1 25 25 10

2 45 20 10

3 60 15 10

4 70 10 10

5 75 5 10

6 79 4 10

7 81 3 10

Step 2: What is the marginal cost?

The marginal cost is what Jerry has to pay to keep the store open for each additional hour.

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HoursOpen

Total Revenue(Total Benefit)

$

MarginalBenefit

(∆ Total Benefit)$

MarginalCost

$

Net Marginal Benefit/Cost

$

0 $0 $0 0 0

1 25 25 10 25-10 = 15

2 45 20 10 20-10= 10

3 60 15 10 5

4 70 10 10 0

5 75 5 10 –5

6 79 4 10 –6

7 81 3 10 –7

Step 3: Compare the marginal benefit and the marginal cost for each hour that the store is open to determine if Jerry should keep it open.

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HoursOpen

Total Revenue(Total Benefit)

$

MarginalBenefit

(∆ Total Benefit)$

MarginalCost

$

Net Marginal Benefit/Cost

$

0 0 0 0 0

1 25 25 10 25-10 = 15

2 45 20 10 20-10= 10

3 60 15 10 5

4 70 10 10 0

5 75 5 10 –5

6 79 4 10 –6

7 81 3 10 –7

The optimal number of hours is 4. For the 4th hour, marginal benefit equals marginal cost.

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Example 2:

Suppose Dell is currently selling 250,000 Pentium 4 laptops per month. A manager at Dell argues, “The last 10,000 laptops we produced increased our revenues by $8.5 million and our costs by $8.9 million. However, because we are making a substantial profit of $25 million from producing 250,000 laptops, I think we are producing the optimal number of laptops.” Briefly explain whether you agree with the manager’s reasoning.

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Solving the problem Step 1: Analyze the given information

Dell is currently selling 250,000 this is the total output

The last 10,000 laptops this is the marginal output, i.e. between 240,000 and 250,000 laptops.

additional 10,000laptops

240,000 laptops 250,000 laptops

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Step 2: Apply the concepts of marginal analysis

What is the another word for the incremental revenue from this last batch of 10,000 laptops and what is the amount of this incremental revenue?

Marginal Revenue or Marginal Benefit = $8.5 million

What is another word for the incremental cost from this last batch of 10,000 laptops and what is the amount of this incremental cost?

Marginal Cost = $8.9 million

Did the last 10,000 laptops yield a net marginal benefit or a net marginal cost?

Net Marginal Cost = $8.5 million - 8.9 million = – 0.4 million

Another way of putting the question: Did the last 10,000 laptops yield a marginal profit or a marginal loss?

Marginal Profit/Loss = Marginal benefit – Marginal Cost = – $0.4 million

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Step 3: Draw your conclusion

The manager is failing to think at the margin. Dell has lost $400,000 ($0.4 million) on the last 10,000 laptops.

The last 10,000laptops generated a loss.

240,000 laptops total profit = $25.4 million

250,000 laptopstotal profit = $25 million