Chapter 1.3 Marginal Reasoning

Nearly everyone has heard of a cost benefit analysis. You consider the full set of costs and the full set of benefits and then make your decision. But to refine that idea, in order to make optimal decisions, a good starting point is to pay attention to the incremental contribution to your costs and benefits. This leads us to marginal reasoning.

You want to break the larger decision down into smaller choices. Ultimately you want to consider how your benefit changes by doing one more of the activity and how your costs change. The incremental change in your total benefit is your marginal benefit. This measures how each additional unit of the activity contributes to the total overall benefit. Whenever marginal benefit is positive, your total benefit is increasing because each additional unit of the activity is adding to the overall benefit. Whenever the marginal benefit is negative, your total benefit is decreasing because each additional unit of the activity is taking away from the overall benefit (you should stop!). The same is true for marginal costs. Marginal cost is defined as the incremental change in total cost. It tells us how total cost changes.

For example, if you take an extra shift at work think about the marginal or incremental contribution. Your benefits include an extra shift's worth of wages and your costs include the lost ability to have done something else with that time.

It’s an application of the marginal principle when you incrementalize, when you literally break down the larger decision into the series of smaller ones. It’s an application of the cost benefit principle when you compare the resulting marginal benefit to the marginal cost.

Marginal reasoning invites us to consider the incremental changes to benefits and costs. Optimization, choosing the optimal level of the activity, requires us to compare that marginal benefit to the marginal cost (an application of the cost benefit principle) and to select the level of the activity where marginal benefit exactly equals marginal cost.

Ex. Think about how many hours you should plan to sleep on a given night. You have an idea of when you’ll need to get up so you set your alarm accordingly. As you settle on the time, you’re implicitly considering the benefit from sleeping for another hour versus the costs and set the alarm at the point where you’re better off getting up. The incremental benefit for each additional hour sleeping is that you're better rested, and the incremental cost is you lose the ability to use that time for anything else e.g. to work or exercise, or spend time with family and so on. Most people don’t get up very early in the morning e.g. before 7am. The single most important explanation is that they simple don’t have a reason to! For most people marginal benefit of sleeping another hour exceeds the marginal cost right on up to, and potentially past, 7am.

Later on we’ll extend these concepts to apply to firms and markets. For a consumer the marginal benefit of making an additional purchase is their willingness to pay for the item. Their marginal cost is the price they have to pay. For the firm, the marginal benefit of selling another unit is the price they’re paid by the customer. The firm then compares the marginal benefit of selling each unit to their own marginal costs (of producing and offering for sale) to determine the optimal level of output to bring to the market.

The consumer keeps buying as long as the marginal benefit is at least as large as the price (the buyer’s marginal cost). The seller keeps selling as long as the price (the seller’s benefit) is at least as large as their marginal costs.