Marginal Analysis for Optimal Decisions

Virtually all of microeconomics involves solutions to optimization problems. The most

interesting and challenging problems facing a manager involve trying either to maximize or to
minimize particular objective functions. Regardless of whether the optimization involves
maximization or minimization, or constrained or unconstrained choice variables, all optimization
problems are solved by using marginal analysis. No other tool in managerial economics is more
powerful than the ability to attack problems by using the logic of marginal analysis.

The results of this chapter fall neatly into two categories: the solution to unconstrained and the
solution to constrained optimization problems. When the values of the choice variables are not
restricted by constraints such as limited income, limited expenditures, or limited time, the
optimization problem is said to be unconstrained. Unconstrained maximization problems can be
solved by following this simple rule: To maximize net benefit, increase or decrease the level of
activity until the marginal benefit from the activity equals the marginal cost of the activity:

When the choice variable is not continuous but discrete, it may not be possible to precisely
equate benefit and cost at the margin. For discrete choice variables, the decision maker simply
carries out the activity up to the point where any further increases in the activity result in
marginal cost exceeding marginal benefit.

Marginal analysis shows clearly why decision makers should ignore average costs, fixed costs,
and sunk costs when making decisions about the optimal level of activities. Since it is marginal
cost that must equal marginal benefit to reach the optimal level of activity, any other cost is
irrelevant for making decisions about how much of an activity to undertake.

In many instances, managers face limitations on the range of values that the choice variables can
take. For example, budgets may limit the amount of labor and capital managers may purchase.
Time constraints may limit the number of hours managers can allocate to certain activities. Such
constraints are common and require modifying the solution to optimization problems. To
maximize or minimize an objective function subject to a constraint, the ratios of the marginal
benefit to price must be equal for all activities,

and the values of the choice variables must meet the constraint.

The two decision rules presented in this chapter will be used throughout this text. If you
remember these rules, economic analysis will be clear and straightforward. These two rules,
although simple, are the essential tools for making economic decisions. And, as the rules
emphasize, marginal changes are the keys to optimization decisions.