1 module 1 economic decision making and marginal analysis economic decision making and marginal...

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Module 1Module 1

Economic Decision Making and Economic Decision Making and Marginal AnalysisMarginal Analysis


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

ObjectivesObjectives

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

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


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

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

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


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ObjectiveObjective 1 1ObjectiveObjective 1 1

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

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

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Objective 1Objective 1: … : … distinguish between the “either-or” decisions distinguish between the “either-or” decisions and the “how much” decisions.and the “how much” decisions.

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

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“ “either–or” decisioneither–or” decision


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


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““how much” decisionhow much” decision


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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.


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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” decisioneither–or” decision


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a. The state government is considering whether to build a public library or a new elementary school. “ “either–or” decisioneither–or” decision

b. Executives at Apple Computer are debating whether or not to produce an additional 300,000 i-Phones this year.““how much” decisionhow 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” decisioneither–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.


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a. The state government is considering whether to build a public library or a new elementary school. “ “either–or” decisioneither–or” decision

b. Executives at Apple Computer are debating whether or not to produce an additional 300,000 i-Phones this year.““how much” decisionhow 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” decisioneither–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” decisionhow much” decision


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To understand To understand the method of economic decision the method of economic decision makingmakingTo understand To understand the method of economic decision the method of economic decision makingmaking

Objective 2Objective 2

In both types of decisions -- the “either-or” and the “how-much” decision -- the rational decision maker weighsweighs the costscosts and benefitsbenefits of each activity.

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Objective 2: … Objective 2: … the method of economic decision the method of economic decision makingmaking

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

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

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

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

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What about the “how-much”“how-much” decision?


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What about the “how-much”“how-much” decision?

The relevant costs and benefits are the marginal or incrementalmarginal or incremental costscosts and the marginal or incrementalmarginal or incremental benefitsbenefits.


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

Objective 3Objective 3

Marginal analysisMarginal analysis is a methodology used to answer the “how-much” question.

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Objective 3: … the principle of marginal analysisObjective 3: … the principle of marginal analysis

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

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Marginal AnalysisMarginal Analysis involves comparing the benefit of taking the next step with the cost of taking that next step.

Objective 3: … Objective 3: … the principal of marginal analysisthe principal of marginal analysis

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The benefit from the next step is called theMarginal BenefitMarginal Benefit


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The cost of taking the next step is called the Marginal Cost. Marginal Cost.

In marginal analysis, the decision maker weighs the marginal benefit marginal benefit against the marginal costmarginal cost before deciding whether to pursue the activity.


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

Do Not Confuse net marginal benefit with marginal benefit


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

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


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

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

If Marginal Benefit = Marginal Cost You have reached the optimaloptimal quantity.


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The Rule of Marginal AnalysisThe Rule of Marginal Analysis The optimal quantity is the quantity at which:

Marginal Benefit = Marginal CostMarginal Benefit = Marginal Cost

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Marginal Benefit > Marginal CostMarginal Benefit > Marginal Cost


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orMarginal Benefit > Marginal CostMarginal Benefit > Marginal Cost

Note: Marginal Benefit ≠ Total Benefit (except when going from 0 to 1)


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orMarginal Benefit > Marginal CostMarginal Benefit > Marginal Cost

Note: Marginal Benefit ≠ Total Benefit (except when going from 0 to 1)

Marginal Cost ≠ Total Cost (except when going from 0 to 1)


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Objective 3: … Applying Marginal AnalysisObjective 3: … Applying Marginal Analysis

Example 1: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?

HoursHoursOpenOpen

Total RevenueTotal Revenue(Total Benefit)(Total Benefit)

$$

0 0

1 25

2 45

3 60

4 70

5 75

6 79

7 81

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HoursHoursOpenOpen


$$

MarginalMarginalBenefit Benefit

(∆ Total Benefit)(∆ 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

Solving the problemSolving the problem

Step 1:Step 1: Determine what is the marginal benefit?

The marginal benefit is the marginal revenuemarginal revenue or incremental revenue.


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HoursHoursOpenOpen


$$



MarginalMarginalCost Cost $$

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:Step 2: What is the marginal cost?

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


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HoursHoursOpenOpen


$$



MarginalMarginalCost Cost

$$

Net Marginal Net Marginal Benefit/CostBenefit/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: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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HoursHoursOpenOpen


$$



MarginalMarginalCost Cost

$$

Net Marginal Net Marginal Benefit/CostBenefit/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

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


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Example 2: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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Step 1:Step 1: Analyze the given information


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


250,000 laptops250,000 laptops

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additional additional 10,00010,000

LaptopsLaptops

240,000 laptops240,000 laptops 250,000 laptops250,000 laptops



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

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


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Step 2:Step 2: Apply the concepts of marginal analysis


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“The last 10,000 laptops we produced increased our revenues by $8.5 million …”

What is the another word for the incremental incremental revenuerevenue 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


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“The last 10,000 laptops we produced increased … our cost by $8.9 million.”

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

Marginal Cost = $8.9 million


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For the last 10,000 laptops,Marginal Revenue or Marginal Benefit = $8.5 millionMarginal Cost = $8.9 million

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


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

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


Net Marginal Profit/Loss = Marginal Cost – Marginal Revenue = $8.5 million - $8.9 million

Net Marginal LossNet Marginal Loss = – $0.4 million– $0.4 million

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

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For the last 10,000 laptops,Marginal Revenue or Marginal Benefit = $8.5 millionMarginal Cost = $8.9 millionMarginal Profit/Loss = Marginal Benefit–Marginal Cost

= –$0.4 million–$0.4 million

The marginal lossmarginal loss is also called a net marginal costnet marginal cost.

Would Dell’s profits be higher if it did not produce the last 10,000 laptops? Yes, since it made a loss on the last 10,000 laptops.

Total Profit from 250,000 laptops = $25.0 million. Total Profit from 240,000 laptops = $25.4 million

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Step 3:Step 3: Draw your conclusion.

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


additional 10,000additional 10,000laptops generated a laptops generated a loss of $0.4 millionloss of $0.4 million

250,000 laptops250,000 laptops Profit = $25 millionProfit = $25 million

240,000 laptops240,000 laptopsProfit = $25.4 millionProfit = $25.4 million

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End of Module 1End of Module 1



song:song: Marginal ManMarginal Manalbum:album: IdentityIdentityartists:artists: Marginal ManMarginal Man

1 module 1 economic decision making and marginal analysis economic decision making and marginal...

Documents

eitheror decisions

eitheror decision slide

types of economic decisions

eitheror decision objective

new elementary school

state government

public library

marginal analysis slide