Costs and Benefits

Costs and Benefits

The importance of marginalism

Maximizing net benefit

? Slogans:

? "Greatest good of the greatest number" ? "Do it if the benefits outweigh the costs" ? "Maximize benefits and minimize costs"

Are imprecise guides to economic decisions whose goal is to maximize economic surplus or net benefit.

Comparing costs and benefits

? Net benefit = Total Benefits - Total Costs

? To maximize NET benefits, find the level of an activity at which

MARGINAL COSTS = MARGINAL BENEFITS (or as close to equality as the problem permits)

MC = MB leads to UNIQUE solution

? Marginal costs = marginal benefits will lead to the unique optimal decision.

? Total Benefit > Total Cost will NOT lead to a unique solution. Since both benefits and costs will normally rise with the level of an activity, many possible levels have total benefits greater than total costs.

? But since marginal costs normally rise and marginal benefits normal decline, there will be one level of an activity at which MC = MB.

MC = MB is easy to apply

? Marginal costs = marginal benefits can be applied more easily than any other rule.

? Maximizing Total Benefit - Total Cost by exhaustive calculation requires knowing all the costs and benefits before taking any decision. Outside of textbooks, we rarely know this.

? The equimarginal principle can be applied in stages: if MB > MC at a given level of activity, increase the activity; if MB < MC, decrease the activity; if MB = MC, stop.

Umbrellas and utility

Click above for the title song

Example: how many umbrellas?

(umbrellas cost $5 each; declining marginal benefit)

Umbrellas 0 1 2 3 4 5 6

Tot.Benefit 0 40 60 75 85 90 93

Tot.Cost 0 5 10 15 20 25 30

Surplus

Total benefits and costs -- graphically

Benefits

100 80 60

40

20

1

2

3

4

5

Umbrellas

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