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Costs and Benefits

Costs and Benefits. The importance of marginalism. Maximizing net benefit. Slogans: “Greatest good of the greatest number” “Do it if the benefits outweigh the costs” “Maximize benefits and minimize costs”

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Costs and Benefits

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  1. Costs and Benefits The importance of marginalism

  2. Maximizing net benefit • Slogans: • “Greatest good of the greatest number” • “Do it if the benefits outweigh the costs” • “Maximize benefits and minimize costs” Are imprecise guides to economic decisions whose goal is to maximize economic surplus or net benefit.

  3. Comparing costs and benefits • Net benefit = Total Benefits - Total Costs • To maximize NET benefits, find the level of an activity at which MARGINAL COSTS = MARGINAL BENEFITS (or as close to equality as the problem permits)

  4. MC = MB leads to UNIQUE solution • Marginal costs = marginal benefits will lead to the unique optimal decision. • Total Benefit > Total Cost will NOT lead to a unique solution. Since both benefits and costs will normally rise with the level of an activity, many possible levels have total benefits greater than total costs. • But since marginal costs normally rise and marginal benefits normal decline, there will be one level of an activity at which MC = MB.

  5. MC = MB is easy to apply • Marginal costs = marginal benefits can be applied more easily than any other rule. • Maximizing Total Benefit - Total Cost by exhaustive calculation requires knowing all the costs and benefits before taking any decision. Outside of textbooks, we rarely know this. • The equimarginal principle can be applied in stages: if MB > MC at a given level of activity, increase the activity; if MB < MC, decrease the activity; if MB = MC, stop.

  6. Umbrellas and utility http://www.geocities.com/oldiesgg/singingin.mid Click above for the title song

  7. Example: how many umbrellas?(umbrellas cost $5 each; declining marginal benefit)

  8. Total benefits and costs -- graphically Benefits 100 80 60 40 20 Umbrellas 1 2 3 4 5

  9. Total benefits – diminishing marginal returns Benefits 100 80 60 40 20 Umbrellas 1 2 3 4 5

  10. Total costs in blue -- $ 5 per umbrella Benefits and Costs Note that total benefits are ALWAYS greater than total costs. 100 80 60 40 20 Total costs rise linearly with quantity – 5 umbrellas cost $ 25 Umbrellas 1 2 3 4 5

  11. Example: how many umbrellas?(direct computation eventually leads to the answer: you maximize surplus with 4 or 5 umbrellas )

  12. Example: how many umbrellas?(computing MARGINAL BENEFIT leads to the same answer as computing all net benefits)

  13. MARGINAL = ADDITIONAL • In the last table, MARGINAL BENEFIT was computed as the difference between the benefit resulting from an additional umbrella and the benefit without the additional umbrella. • For example, MB at 4 umbrellas is equal to Total Benefit at 4 minus Total Benefit at 3 or 85 – 75 = 10.

  14. Marginal benefits and costs -- graphically Benefits 40 35 30 25 20 15 10 5 MB = MC Marginal cost = $ 5 Umbrellas 1 2 3 4 5

  15. Advantages of marginalism • Step-by-step procedure: even if we did not know all the costs and benefits, we can take another step (increase the level of activity) as long as MB > MC. “How much would you be willing to pay for 5 umbrellas?” is a hard question to answer; “How much would you pay for another umbrella?” is an easier question to answer. • Faster “what-if?” recalculations. What if the price of umbrellas were $8? $15? Using the “total benefit” method requires every calculation to be repeated; but we could read the result quickly from the marginal table.

  16. Tomatoes and Diminishing Marginal Returns

  17. Example: how much compost ?(cost of compost 50 cents per pound; price of tomatoes 30 cents per pound)

  18. Tomatoes and compost • What if the price of compost rises to $ 1.00 a pound? (answer: buy 2 pounds) • What if the price of tomatoes rises to 60 cents a pound (with compost at 50 cents)? Multiply marginal product by $0.60 to get a new “marginal benefit” column; compare to the price of compost. • Compute the net benefit in the original case and the above two problems to satisfy yourself that the MB = MC rule will maximize net benefit in all cases.

  19. Example: how much compost ?(cost of compost 50 cents per pound; price of tomatoes $ 0.60 per pound)

  20. Marginal benefits and costs -- graphically Marginal Benefits 3.00 2.00 1.00 0.50 MB = MC at between 5 and 6 pounds of compost Marginal cost = 50 cents 1 2 3 4 5 Fertilizer

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