marginal benefit/marginal opportunity cost analysis refining benefit/cost analysis

Marginal Benefit/Marginal Opportunity Cost

Analysis

Refining Benefit/Cost Analysis

The Margin

Do you really want to give up some ____to gain some ______?Is it worth it?A thing worth doing may not be worth doing well.When is enough too much?

.

MARGINAL• Large fries and medium coke or large coke

and medium fries? You don’t have enough money for large coke and large fries.

• You choose the large fries; you give up the large coke.

• Were the additional fries better than the larger coke would have been?

http://images.google.com/imgres?imgurl=http://www.ifanca.org/images/graphics/fries.jpg&imgrefurl=http://www.ifanca.org/newsletter/2001_06.htm&h=148&w=145&sz=10&tbnid=qKZTZM8sJ5MJ:&tbnh=89&tbnw=88&start=13&prev=/images%3Fq%3Dfrench%2Bfries%26hl%3Den%26lr%3D

http://images.google.com/imgres?imgurl=http://otuts.homestead.com/~site/clipart/food/French_Fries.GIF&imgrefurl=http://otuts.homestead.com/Merc_7.html&h=255&w=205&sz=4&tbnid=GlCmn_k0LS8J:&tbnh=105&tbnw=85&start=56&prev=/images%3Fq%3Dfrench%2Bfries%26start%3D40%26hl%3Den%26lr%3D%26sa%3DN

MARGINAL

• Sleep 15 minutes longer or get up now and have 15 minutes more to do your hair, enjoy your breakfast, read the newspaper, get to work/school early, or whatever you would do during those additional 15 minutes.

• What is the marginal benefit of an additional 15 minutes of sleep? What is the marginal opportunity cost?

• Will the additional sleep be worth the marginal opportunity cost?

Unfortunate consequences of scarcity

• You will never be the best parent you could be.• You will never be the best student you could be.• You will never be the best spouse you could be. • I will never be the best teacher I could be.• Maximize your LifePointAverage, while working

on your GPA, Parent Point Average, Teacher Point Average!

Using Marginal Benefit/Marginal Cost Analysis

• You have limited resources? How should you use them?

• If you use a resource for more of one activity, you will do less of another activity.

• In making a choice to use resources, does the choice provide greater additional benefits than the alternative you would have chosen?

What is the benefit and what is the opportunity cost?

• How good a parent are you? – Your daughter has a hockey game and

your boss has called n “emergency” meeting. (MB and MOC)

• How good a student are you? – You have a test tomorrow and your boss

says she needs you at work. (MB and MOC)

What is the benefit and what is the opportunity cost?

• How good a spouse are you? – Your wife wants you to go to her mother’s

with her but you really need to write the term paper. (MB and MOC)

• How good a teacher will I be?– I want to prepare a lesson plan but my son

is asking for help with algebra. (MB and MOC)

Marginal Analysis•

We try to make the best use of our scarce resources by using them in particular activities (work, parenting, spousing) as long as the marginal benefit is greater than the marginal opportunity cost.

• We attempt to maximize our Life Point Average, not just our GPA or our income, or any other single goal. We try to do our best with the “basket” of goals.

Cleaning the brown lake

• The lake is dirty.

• Let’s clean it.

• How clean?

• What are the benefits of different degrees of clean?

• What are the marginal opportunity costs of different degrees of clean?

The relevant questions for a parent/student

• If I put one more hour of human capital into studying,– what difference will it make to my grade

(benefit), and– what difference will it make to my children

in the short run (cost)?

• Is the additional studying the best use of my limited human capital?

Juan or George?

Who to date?

• If you go with George, you gain some fame, but you give up some comfort.

• Do you really want to give up some comfort and ease with Juan for some fame with George?

• Marginal Benefit = some fame; Marginal Opportunity Cost = some comfort

Marginal Analysis –What’s the difference?

• Marginal is the change that results from a little more or a little less of an activity

• When comparing two alternatives – what is the marginal benefit and the marginal opportunity cost of both alternatives?

• You only use marginal analysis when you compare two alternatives and are going to do more of one and less of another or more of one and not more of another.

• Is the marginal benefit worth what I will be giving up?

The marginal question

• Do you really want to give up this much

of ________,

• In order to gain this much of ________?

Consumer Decisions

• I Pod – how much memory? What does the extra memory give me, what would I do with the extra money if I don’t get the bigger memory?

• I’m looking at two cars. One is $5000 more than the other. What does the additional $5000 get me, what would I do with the $5000 if I get the less expensive car?

Study Decisions

• Two tests tomorrow, econ and math.

• It’s 5 PM, I have studied two hours for econ, nothing for math.

• I have four hours left. How should I use my human capital in those four hours? More econ and some math, no econ, all math, some combination.

Resource Decisions

• How much California land for wildlife preserves; how much for housing?

• How much land for the Spotted Owl; how much for timber?

• How many resources for Gifted and Talented programs; how many for Head Start?

Marginal Opportunity CostHershey’s or Hershey’s with Almonds

A B

C

Chocolate

More chocolateAlmonds

If you choose A, you give up some chocolate; if you choose B, you give up almonds.

Marginal Opportunity Cost

A BC

A DIFFICULT DECISION

Marginal Opportunity Cost

A BC

AN EASY DECISION

The Marginal Principle

• How far should I pursue any single activity, knowing that every resource I use has an opportunity cost; every resource could be used some other way?

• If I gain more than I give up (if the MB is greater than the MOC), I should use the resource in this activity.

Marginal Cost to play each round

Round 1 Round 2 Round 3 Round 4 Round 5

$1.50

$1.00

MC

MB

Marginal benefit – marginal cost



$1.50

$1.00

$1.45

$1.20

MC

MB




$1.50

$1.00

$1.45

$1.20

$1.35

$1.25

MC

MB




$1.50

$1.00

$1.45

$1.20

$1.35

$1.25

$1.32

$1.27

MC

MB




$1.50

$1.00

$1.45

$1.20

$1.35

$1.25

$1.32

$1.27

$1.30

$1.29

MC

MB


How many rounds to play?

RoundRound 11 22 33 44 55 66

Marginal Marginal BenefitBenefit

$1.5$1.500

$1.4$1.455

$1.3$1.355

$1.32$1.32 $1.30$1.30 $1.2$1.255

Marginal Marginal OpportunitOpportunity Costy Cost

$1.0$1.000

$1.2$1.200

$1.2$1.255

$1.27$1.27 $1.29$1.29 $1.3$1.355

Marginal Marginal Net GainNet Gain

$.50$.50

Total GainTotal Gain $.50$.50


RoundRound 11 22 33 44 55 66


$1.5$1.500

$1.4$1.455

$1.3$1.355

$1.32$1.32 $1.30$1.30 $1.2$1.255

Marginal Marginal OpportunitOpportunity Costy Cost

$1.0$1.000

$1.2$1.200

$1.2$1.255

$1.27$1.27 $1.29$1.29 $1.3$1.355


$.50$.50 $.25$.25

Total GainTotal Gain $.50$.50 $.75$.75


RoundRound 11 22 33 44 55 66


$1.5$1.500

$1.4$1.455

$1.3$1.355

$1.32$1.32 $1.30$1.30 $1.2$1.255

Marginal Marginal Opportunity Opportunity CostCost

$1.0$1.000

$1.2$1.200

$1.2$1.255

$1.27$1.27 $1.29$1.29 $1.3$1.355


$.50$.50 $.25$.25 $.10$.10 $.05$.05 $.01$.01 -$.10-$.10

Total GainTotal Gain $.50$.50 $.75$.75 $.85$.85 $.90$.90 $.91$.91 $.81$.81

How much of a particular activity? Know when to move on.• Pursue activities as long as the marginal benefit

exceeds the marginal opportunity cost.• Pursue activities as long as:

MB > MOC.• If the marginal benefit of another unit of the

activity is greater than the marginal opportunity cost, go for it!

• If the marginal benefit of another unit of the activity is less than the marginal opportunity cost, stop!

The Marginal Principle: Pursue all activities up to the

point where:

Marginal Principle

• MB greater than MOC, go for

it!

• MB less than MOC, go back;

you have gone too far.

Marginal Analysis in Using Society’s Resources

(1)(1)AlternativeAlternative

(2)(2)Penalty Penalty

for for carryingcarrying

(3)(3)Penalty Penalty

for for displayingdisplaying

(4)(4)New New beds beds

neededneeded

(5)(5)Total Total Cost Cost

($mil)($mil)

(6)(6)Marginal Marginal

Cost Cost ($mil)($mil)

1

2

3

5

3

5 10

6

4700

4200

123 $6.2

$210

$235

$6.1

$203.8

$228.84

00 0

5

0 --

Marginal Value of Penalties for carrying and/or displaying gunsMarginal Value of Penalties for carrying and/or displaying guns

Where to spend $10 million? How much to clean?

Air Ground Water

Alternative 1 50% 100% 25%



I’m soft on crime

Marg Ben Marg Opp Cost

1 Three Strikes 10% $50 mill

2 Stricter Enforce 8% $25 mill

ment

3 Address social 50% $55 mill

issues

How much safety?

•Cars?

•Airport security?

•Civil liberty?

Education Average Income Marginal Income

Not High School Grad

High School Graduate

Associate

4 yr College Graduate

Master’s

Doctorate

Professional

18,226

27,280

34,177

51,194

60,445

89,734

112,845

9,054 = 50%

Education

Source: U.S. Census Bureau, Statistical Abstract of the U.S. 2004-2005




Associate


Master’s

Doctorate

Professional

18,226

27,280

34,177

51,194

60,445

89,734

112,845

9,054 = 50%

6,897 = 25%

Education





Associate


Master’s

Doctorate

Professional

18,226

27,280

34,177

51,194

60,445

89,734

112,845

9,054 = 50%

6,897 = 25%

17,017 = 50%

Education





Associate


Master’s

Doctorate

Professional

18,226

27,280

34,177

51,194

60,445

89,734

112,845

9,054 = 50%

6,897 = 25%

17,017 = 50%

9,251 = 18%

Education





Associate


Master’s

Doctorate

Professional

18,226

27,280

34,177

51,194

60,445

89,734

112,845

9,054 = 50%

6,897 = 25%

17,017 = 50%

9,251 = 18%

29,289 = 48%

Education





Associate


Master’s

Doctorate

Professional

18,226

27,280

34,177

51,194

60,445

89,734

112,845

9,054 = 50%

6,897 = 25%

17,017 = 50%

9,251 = 18%

29,289 = 48%

23,111 = 26%

Education


How much education and training is right for you?

• High school• High school plus vocational training• Two year college degree• Four year college degree• Etc.• The rule: Continue your education as long as

the marginal benefit of additional education is greater than the marginal opportunity cost of additional education.

The problem• The rule is simple.• The estimates of marginal benefit and

marginal cost are not. – The estimates are of future benefits and

costs.– Most of us are not very good at predicting the

future– Those who gain and those who pay the cost

are often different.

Sunk Cost

You got to know when to hold ‘em

Know when to fold ‘em

Know when to walk away

And know when to run

SUNK COSTS vs.MARGINAL COST

SUNK COSTS (backward looking – irrelevant)

MARGINAL COSTS

(the consequences of choices lie in the future - only relevant costs)

Whiteout!What is the marginal

benefit of your being there for the next three days?

What is the marginal benefit of the best alternative?

What should you do?

No Surf!What is the marginal

benefit of staying for the next six hours?


What should you do?

A terrible movie What is the marginal

benefit of staying there for the next two hours?


What should you do?

A horrible marriage?What is the marginal

benefit of staying with the bum for the next fifty years?


What should you do?

Use marginal analysis to explain why you don’t want to

join the “Clean Plate Club.”

Was there any mention of “sunk costs” in any of these

decisions?• Skiing

• Surfing

• Watching a movie

• Marriage

SUNK COSTS

• You have no control over sunk costs so they are not part of the decision-making process

SUNK COSTS vs.MARGINAL COST

SUNK COSTS (backward looking – irrelevant)

MARGINAL COSTS

(the consequences of choices lie in the future - only relevant costs)

The past is gone; you can do nothing about it. The present is now. The future is determined by your decisions now. Consider those things that you can control, not those that you can’t.

Marginal Analysis is Forward Looking; Sunk Costs are

Irrelevant.• I paid for this movie; I’m going to sit here

whether I enjoy it or not.• I have to fix the transmission; I just bought

$500 worth of tires.• I have to stay with my husband; I’ve put 23

years into this marriage.• I paid for this dessert; I have to eat it all. • This book is awful but I’ve read 150 pages so

I have to finish it.

Main Points

• Marginal benefit is the addition to total benefits from one more unit of an activity.

• Marginal cost is the addition to total cost of one more unit of an activity.

• Every economic decision has a marginal benefit and a marginal cost.

• Marginal analysis always identifies the differences between two alternatives.

Main Points

• Marginal analysis compares the marginal benefits with the marginal opportunity costs of two alternatives.

• The marginal principle states that the use of a resource should be continued if the marginal benefit of additional use of the resource is greater than the marginal opportunity cost and should be discontinued if the opposite is true. MB greater than MOC, continue; MB less than MOC, stop.

Main Points

• Estimations of marginal benefits and marginal opportunity costs are subjective and difficult.

• A decision maker compares the future marginal benefit and future marginal opportunity costs of the best two future alternatives. Sunk costs are irrelevant.

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