Managerial Economics Thomas

eighth edition Maurice

Chapter 3

Marginal Analysis for

Optimal Decision Making
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Optimization
• An optimization problem involves
the specification of three things:
• Objective function to be maximized or
minimized
• Activities or choice variables that
determine the value of the objective
function
• Any constraints that may restrict the
values of the choice variables
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Choice Variables
• Choice variables determine the
value of the objective function
• Continuous variables
• Can choose from uninterrupted span
of variables
• Discrete variables
• Must choose from a span of variables
that is interrupted by gaps

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Net Benefit
• Net Benefit (NB)
• Difference between total benefit (TB)
and total cost (TC) for the activity
• NB = TB – TC

• Optimal level of the activity (A*) is

the level that maximizes net benefit

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Optimal Level of Activity
(Figure 3.1)
TC
G
4,000 F • TB
•
Total benefit and total cost (dollars)
D
•
3,000
B
•D’
2,310
•
2,000
C NB* = $1,225

1,085 •
1,000 • B’
•C’
A
0 200 350 = A* 600 700 1,000
Level of activity
Panel A – Total benefit and total cost curves
Net benefit (dollars)

M
1,225
1,000 •c’’ •
600 •
d’’
f’’ A
0 200 350 = A* 600
• 1,000
Level of activity NB
Panel B – Net benefit curve
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Marginal Benefit & Marginal Cost

• Marginal benefit (MB)
• Change in total benefit (TB) caused by
an incremental change in the level of
the activity
• Marginal cost (MC)
• Change in total cost (TC) caused by an
incremental change in the level of the
activity

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Marginal Benefit & Marginal Cost

Change in total benefit TB

MB  
Change in activity A

Change in total cost TC

MC  
Change in activity A

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Relating Marginals to Totals

• Marginal variables measure rates
of change in corresponding total
variables
• Marginal benefit & marginal cost are
also slopes of total benefit & total
cost curves, respectively

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Relating Marginals to Totals
(Figure 3.2)
TC
G
4,000 100 F • TB
•
Total benefit and total cost (dollars)
320
•D
D’•
3,000 100 820
520
100 •B 100
2,000
640
•C
1,000
B’
• 520

C’
•
100
340

100 A
0 200 350 = A* 600 800 1,000
Level of activity
Panel A – Measuring slopes along TB and TC
Marginal benefit and marginal

MC (= slope of TC)

8 •d’ (600, $8.20)

c (200, $6.40)
6 • b
5.20 •
cost (dollars)

4 d (600, $3.20)
•c’ (200, $3.40) •
2 MB (= slope of TB)
g A
0 200 350 = A* 600 800
•
1,000
Level of activity
Panel B – Marginals give slopes of totals
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Using Marginal Analysis to Find
Optimal Activity Levels
• If marginal benefit > marginal cost
• Activity should be increased to reach
highest net benefit
• If marginal cost > marginal benefit
• Activity should be decreased to reach
highest net benefit
• Optimal level of activity
• When no further increases in net benefit
are possible
• Occurs when MB = MC
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Using Marginal Analysis to Find A*

(Figure 3.3)

MB = MC
Net benefit (dollars)

MB > MC MB < MC

100 M
•
300 •
c’’
100

d’’
• 500

A
0 200 350 = A* 600 800 1,000
NB
Level of activity

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Unconstrained Maximization with
Discrete Choice Variables
• Increase activity if MB > MC
• Decrease activity if MB < MC
• Optimal level of activity
• Last level for which MB exceeds MC

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Irrelevance of Sunk, Fixed, &
Average Costs
• Sunk costs
• Previously paid & cannot be recovered
• Fixed costs
• Constant & must be paid no matter the level
of activity
• Average (or unit) costs
• Computed by dividing total cost by the
number of units of the activity
• These costs do not affect marginal cost
& are irrelevant for optimal decisions
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Constrained Optimization
• The ratio MB/P represents the
additional benefit per additional
dollar spent on the activity
• Ratios of marginal benefits to
prices of various activities are used
to allocate a fixed number of
dollars among activities

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Constrained Optimization
• To maximize or minimize an
objective function subject to a
constraint
• Ratios of the marginal benefit to price
must be equal for all activities
• Constraint must be met
MBA MBB MBZ
  ... 
PA PB PZ
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