MARGINAL ANALYSIS
Since resources are scarce and we cannot have everything that we want, tough choices must be made. The concept of opportunity cost reminds us that every time we make a choice, something else must be given up. Economics provides us with a set of tools that can help us to make better choices. Often times, the best decision is made by weighing the marginal benefits aganist the marginal costs.
Powerpoint slides are available for this module.
Utilitarianism
Economic theory is often based upon the philosophy of utilitarianism. The foundation of utilitarian philosophy is "the greatest good for the greatest number." In other words, utilitarian philosophy suggests that decisions be made with the ultimate objective of maximizing societal welfare. Sometimes this choice is easy. For example, when deciding what type of new car to purchase, a consumer should purchase the one that she likes the best given her tastes, so long as it is within her budget. In other words, a consumer can maximize utility by purchasing the things that she likes the best. Other times,the utilitarian principle is not so easy to apply. Should health care be denied to some of our elderly so that the young can have better health care? Should more education funds be devoted to the inner cities at the expense of reducing funds to children in the suburbs? The "greatest good for the greatest number" hinges directly on how we define and quantify "good." To help us answer these types of questions, we need to understand the concepts of marginal costs and marginal benefits.
Marginal Costs
Marginal Costs are the additional costs imposed when one more unit is produced. If the cost of making 9 pieces of pizza is $90 and the cost of making 10 pieces is $110, the marginal cost of producing the tenth piece of pizza is $20. The table below illustrates the relationship between production, total costs,and marginal costs. Notice that total costs always rise as production increases even though marginal costs may not rise.
| Quantity | Total Cost | Marginal Cost |
| 0 | 0 | -- |
| 1 | 5 | 5 |
| 2 | 10 | 5 |
| 3 | 17 | 7 |
| 4 | 25 | 8 |
| 5 | 34 | 9 |
| 6 | 44 | 10 |
| 7 | 58 | 14 |
| 8 | 73 | 15 |
| 9 | 90 | 17 |
| 10 | 110 | 20 |
Marginal costs tend to rise as production increases. One explanation for this is that when a firm grows very large, it becomes more and more difficult to manage the organization and costs rise. Another possibility is that producing more and more of a particular product becomes more difficult due to technology or resource limitations. When trying to clean up the air, for example, the first efforts are relatively inexpensive. A law can mandate, for example, that the dirtiest cars be taken off the road. But as one tries to make the air cleaner and cleaner, more expensive technology is needed. Therefore, marginal costs rise. The rise in Marginal Costs is shown in the chart above.
Marginal Benefits
Marginal Benefits are the additional benefits received when one more unit is produced. Benefits can be expressed in terms of units of utility or satisfaction, or sometimes they can be expressed in dollar amounts. The table below charts the marginal and total benefits from consuming pieces of pizza. The utility units are expressed in dollar terms.
| Quantity | Total Benefits | Marginal Benefits |
| 0 | 0 | -- |
| 1 | 30 | 30 |
| 2 | 55 | 25 |
| 3 | 75 | 20 |
| 4 | 90 | 15 |
| 5 | 103 | 13 |
| 6 | 113 | 10 |
| 7 | 121 | 8 |
| 8 | 126 | 5 |
| 9 | 130 | 4 |
| 10 | 132 | 2 |
Marginal Benefits tend to fall as consumption of a good or service increases. Notice that the marginal benefit from the second piece of pizza is 25 units, but the marginal benefit of the tenth piece is only 2 units. This is because the first few pieces of pizza are very appetizing when one is hungry. But with each additional piece, the added benefits to the person diminish.
Generally speaking, the marginal benefits curve slopes downward because we tend to like variety and too much of the same thing gets very old. For instance, when we are used to breathing filthy air and that air has been cleaned for the first time, the health benefits are large. But when one breathes relatively clean air already and that air is made even cleaner, the health benefits are not as dramatic. The chart of total and marginal benefits above demonstrates this concept.
Economic Efficiency
Economic efficiency in our pizza example occurs where the MB and MC curves intersect. This occurs at a quantity of six pieces of pizza.
In general, the efficient level of output is where the Marginal Benefits just equal the Marginal Costs (point Q*). This is also the level at which the principle of utilitarianism holds. Why is this the case?
If production is less than Q*, for example at QL, then society could benefit overall by producing more. This is because the gains to society (measured by marginal benefits) exceed the costs to society (measured by marginal costs). There will be a net gain to society of the difference between the marginal benefits and the marginal costs.
If production is greater than Q* at QH, then society could benefit by producing less. This is because when we reduce output, the costs imposed on society fall by more than the fall in marginal benefits. Therefore, the greatest good for the greatest number occurs at the intersection of marginal costs and marginal benefits.
Sometimes, the marginal benefits and costs are not "continuous"and we must make decisions about entire projects based upon cost/benefit analysis. Suppose the courts must decide whether or not to allow hundreds of acres of old-growth redwoods to be logged. One could do a cost/benefit analysis to determine what the benefits are to society for harvesting the timber versus the benefits for not harvesting the timber and preserving the forest and the ecosystems. The efficient outcome would be to cut the trees until marginal benefits equal marginal costs. This result may not be possible, however, if an all or nothing decision must be made. The recent compromise in the Headwaters Forest in which most old growth was preserved but other lands and cash were traded in return, certainly did not please either side completely, but perhaps the result was more efficient (but not necessarily more fair) than a solution that allowed the entire area to be harvested, or a decision to ban production completely.
The example over logging demonstrates that the costs and benefits arenot always easily transferable into dollars. This makes the decisions very difficult and inherently more subjective.
The Moral Vacuum of the Efficiency Standard
Cost-Benefit analysis and the efficiency standard are extremely useful tools to approaching complex problems. However, the efficiency standard generally has nothing to say about the morality or fairness of a particular decision. Equity and efficiency are two different things. One must not use the efficiency standard indiscriminately or else he/she arrives at some ridiculus or dangerous conclusions.
For example, suppose the law mandates that the water in a town be cleaned to the point until the marginal costs to society exceed the marginal benefits.At this level, the water is still too dirty to swim in and children who drink from the water are exposed to lead poisoning. Society may decide to clean up the water even more than the efficient level because we do not want to harm children. Even though the solution may not be efficient, it may be more fair.
In health care, the efficient outcome may be to only provide health services to those to whom the benefits from being made healthier exceed the costs of the health care. Therefore, elderly citizens may not get the treatment they require because society sees few benefits in terms of life extension. Again, the efficient outcome is not always the fair outcome and society may decide that it is more equitable to provide quality health care to the elderly.
