Scribbling in the MarginsDecember 5, 2012

Posted by tomflesher in Micro, Teaching.
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3. Rational people think at the margin.

That’s one of Mankiw’s Ten Principles of Economics. (#3, in fact). What does it mean?

The usual definition of “marginal” is “additional.” In other words, the marginal cost of something is the cost of buying another one. So, we can rephrase Number Three as “Rational people think about the next one of whatever it is they’re thinking about.” We can also think about marginal benefits.

How much would you pay for a Dove Dark Chocolate bar?1 Whatever your answer, that’s the benefit that a Dove bar affords you. Currently, I have zero Dove bars, so the first Dove bar I bought would give me a benefit. Economists measure benefit in two ways: either in utility, which is an abstract concept of “happiness points,” or in dollars, which are, well, dollars. If I’d pay $1.50 for a Dove bar, then my marginal benefit for a Dove bar is$1.50. Because this sounds simple, economists sometimes make this sound more complicated by calling it money-metric utility.

After I eat the first Dove bar, I really wouldn’t want another 0ne – at least, not as much as the first. I’m willing to pay $1.50 for the first one, but$1.50 would be too much for the second. I might buy two if they’re on special for two for $2.50, but I wouldn’t pay much more than that. That means I value the second Dove bar at$1.00, or the benefit I’d get from two bars minus the benefit I’d get from one bar.2 This is pretty normal – marginal benefits, or marginal utility, is decreasing in quantity for most goods. That’s just a fancy way of saying that the second one isn’t as good as the first, and the third isn’t as good as the second. The technical term for that is diminishing marginal returns.

The marginal cost is just the cost of the additional bar. Usually, stores have one price per bar, no matter how many you buy. My local grocery store sells Dove Bars for $1.25 each. Since I’d pay$1.50 for that bar, I’d buy it, and I’d be better off to the tune of $0.25 because I got$1.50 worth of utility for only $1.25. (Economists call that$0.25 consumer surplus.)

Should I buy the second one?

If you make the decision all at once, you’d say that I value two bars at $2.50, so why not? Here’s the problem: that gives me a total benefit of$2.50 at a total cost of $2.50, for a consumer surplus of$0. If I buy the first bar, I get a consumer surplus of $0.25. Buying the second bar amounts to paying$1.25 for something I only value at $1, so I’d get a consumer surplus of -$0.25. Thinking at the margin allows me to spend that last $1 on something I actually value that much. The fundamental criterion for making decisions in economics: do something only if its Marginal Benefit is at least as much as its Marginal Cost. In other words, don’t buy something unless you’re at least breaking even. Note: 1 Okay, that’s a 24-pack. How much would you pay for a 24-pack? Probably not more than 24-times-your-valuation. But we’ll chat about that later. 2 Mathematically, marginal benefit is defined as $\frac{\Delta(Benefit)}{\Delta(Quantity)}$, with Δ meaning “change.” Here, the change in benefit is$1.00 and the change in quantity is 1.