Chapter 3

Balancing Costs and Benefits

McGraw-Hill/Irwin

Copyright 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.

Main Topics
Maximizing benefits less costs Thinking on the margin Sunk costs and decision-making

3-2

Maximizing Net Benefit

Net benefit: total benefit minus total cost Total cost must include opportunity cost Opportunity cost: the cost associated with foregoing the opportunity to employ a resource in its best alternative use Right decision is the choice with the greatest difference between total benefit and total cost
3-3

Car Repair Example: Benefit Schedule

Mechanics time is available in one-hour increments Maximum repair time is 6 hours The more time the car is repaired, the more it is worth
Table 3.1: Benefits of Repairing Your Car
Repair Time (Hours) 0 Total Benefit ($) 0

1
2 3 4 5

615
1150 1600 1975 2270

2485
3-4

Car Repair Example: Cost Schedule

Table 3.2: Costs of Repairing Your Car
Repair Time (Hours) 0 1 2 3 Cost of Mechanic and Parts ($) 0 140 355 645 Lost Wages from Pizza Delivery Job ($) 0 10 25 45 Total Cost ($) 0 150 380 690

4
5 6

1005
1440 1950

75
110 150

1080
1550 2100

3-5

Car Repair Example: Maximizing Net Benefit

How should you decide how many hours is the right number to have your car repaired? Recall that every hour in the shop will bring both benefits and costs Choose the number of hours where benefits exceed costs by the greatest amount
3-6

Car Repair Example: The Right Decision

Table 3.3: Total Benefit and Total Cost of Repairing Your Car
Repair Time (Hours) 0 Total Benefit ($) 0 Total Cost ($) 0 Net Benefit ($)

1
2 3 4 5 6

615
1150 1600 1975 2270 2485

150
380 690 1080 1550 2100

3-7

Car Repair Example: The Right Decision

Table 3.3: Total Benefit and Total Cost of Repairing Your Car
Repair Time (Hours) 0 Total Benefit ($) 0 Total Cost ($) 0 Net Benefit ($) 0

1
2 3 4 5 6

615
1150 1600 1975 2270 2485

150
380 690 1080 1550 2100

465
770 910 895 720 385

3-8

Car Repair Example: The Right Decision

Table 3.3: Total Benefit and Total Cost of Repairing Your Car
Repair Time (Hours) 0 Total Benefit ($) 0 Total Cost ($) 0 Net Benefit ($) 0

1
2 Best Choice 3 4 5 6

615
1150 1600 1975 2270 2485

150
380 690 1080 1550 2100

465
770 910 895 720 385

3-9

Car Repair Example: Graphical Approach

(Figure 3.1)

Data from Table 3.3 are shown in this graph Costs are in red; benefits are in blue The best choice is where benefits > costs and the distance between them is maximized This is at 3 hours, net benefit = $910

Total Benefit, Total Cost ($) 2400

2000

710

1600

1200

910

800

400

465

Repair Hours

Best Choice

3-10

Maximizing Net Benefit: Finely Divisible Actions

Many decisions involve actions that are more finely divisible E.g. mechanics time available by the minute In these cases can use benefit and cost curves rather than points or a schedule to make the best decision Underlying principle is the same: maximize net benefit
3-11

Car Repair Example: Finely Divisible Benefit

(a): Total Benefit

Horizontal axis measures hours of mechanics time Vertical axis measures in dollars the total increase in your cars value B(H)=654H-40H2

Total Benefit ($)

B
2270

1602

614

Hours (H)

3-12

Car Repair Example: Finely Divisible Cost

(b): Total Cost

Vertical axis measures total cost in dollars Includes opportunity cost C(H)=110H+40H2

Total Cost ($)

1550

690

150

Hours (H)

3-13

Car Repair Example: Finely Divisible Net Benefit

Best choice is 3.4 hours of repair, maximizes net benefit Net benefit with finely divisible choices is greater than in previous example; more flexibility allows you to do better
(c): Total Benefit versus Total Cost Total Benefit Total Cost ($)

1761.20

924.80

836.40

2 Hours (H)

3 3.4

3-14

Net Benefit Curve

(Figure 3.3)

Can also graph the net benefit curve Vertical axis shows B-C, net benefit Best choice is the number of hours that corresponds to the highest point on the curve, 3.4 hours

Net Benefit ($)

924.80

BC

2 Hours (H)

3 3.4

3-15

Thinking on the Margin

Thinking like an economist Another approach to maximizing net benefits Capture the way that benefits and costs change as the level of activity changes just a little bit
For any action choice X, the marginal units are the last DX units, where DX is the smallest amount you can add or subtract
3-16

Marginal Cost
The marginal cost of an action at an activity level of X units is equal to the extra cost incurred due to the marginal units, divided by the number of marginal units
MC DC C ( X ) C ( X DX ) DX DX

3-17

Car Repair Example: Marginal Cost

Marginal cost measures the additional cost incurred from the marginal units (DH) of repair time If C(H) is the total cost of H hour of repair work, the extra cost of the last DH hours is DC = C(H) C(H-DH) To find marginal cost, divide this extra cost by the number of extra hours of repair time, DH
3-18

Car Repair Example: Marginal Cost

So the marginal cost of an additional hour of repair time is:
DC C ( H ) C ( H DH ) MC DH DH

Using the data from Table 3.2, if H= 3, we see:

C (3) C (3 1) MC 690 380 310 1

3-19

Car Repair Example: Marginal Cost Schedule

Table 3.5: Total Cost and Marginal Cost of Repairing Your Car
Repair Time (Hours) Total Cost ($) Marginal Cost (MC) ($/hour)

0
1 2 3

0
150 380 690

150 230 310

4
5 6

1080
1550 2100

390
470 550

3-20

Marginal Benefit
The marginal benefit of an action at an activity level of X units is equal to the extra benefit produced due to the marginal units, divided by the number of marginal units
MC DB B( X ) B( X DX ) DX DX

3-21

Car Repair Example: Marginal Benefit

Marginal benefit measures the additional benefit gained from the marginal units (DH) of repair time This parallels the definition and formula for marginal cost

3-22

Car Repair Example: Marginal Benefit

The marginal benefit of an additional hour of repair time is:
DB B( H ) B( H DH ) MC DH DH

Using the data from Table 3.1, if H= 3, we see:

B(3) B(3 1) MC 1600 1150 450 1

3-23

Car Repair Example: Marginal Benefit Schedule

Table 3.6: Total Benefit and Marginal Benefit of Repairing Your Car
Repair Time (Hours) Total Benefit ($) Marginal Benefit (MB) ($/hour)

0
1 2 3 4

0
615 1150 1600 1975

615 535 450 375

5
6

2270
2485

295
215

3-24

Marginal Analysis and Best Choice

Comparing marginal benefits and marginal costs can show whether an increase or decrease in a level of an activity raises or lowers the net benefit Increase level if MB of doing so is greater than MC; if MC of last increase was greater than MB, decrease level At the best choice, a small change in activity level cant increase the net benefit
3-25

Marginal Analysis and Best Choice

Table 3.7: Marginal Benefit and Marginal Cost of Repairing Your Car
Repair Time (Hours) Marginal Benefit (MB) ($/hour) Marginal Cost (MC) ($/hour)

0
1 2 Best Choice 3

615 535 450 > > >

150 230 310

4
5 6

375
295 215

<
< <

390
470 550

3-26

Marginal Analysis with Finely Divisible Actions

Can conduct the same analysis if choices are finely divisible by using marginal benefit and marginal cost curves Derive marginal benefit and marginal cost from total benefit and total cost curves Marginal benefit at H hours of repair time is equal to the slope of the line drawn tangent to the total benefit function at point Usually called simply the slope of the total benefit curve at point D
3-27

Marginal Benefit
Using Calculus

dBH MBH dH
This is the slope of the Total Benefit Curve B(H).

Car Repair Example: Finely Divisible Marginal Benefit

Let DH' = the smallest possible change in hours of car repair Adding the last DH of repairs increases total benefit from point F to point D in Figure 3.4 (on the next slide), this equal to: DB B( H ) B( H DH ) Recall that marginal benefit is DB' /DH'

3-29

Relationship between Total Benefit and Marginal Benefit

Total Benefit ($)

(Figure 3.4)

Slope = MB

B( H )

D
Slope = MB =

DB' '
B( H DH' ' )

DB' / DH'
E

DB'

B( H DH' )

Slope = MB = DB' '

/ DH' '

H DH'

H DH' ' DH' ' DH'

H
Hours (H)

3-30

Relationship between Total Benefit and Marginal Benefit

Tangents to the total benefit function at three different numbers of hours (H = 1, H = 3, H = 5) Slope of each tangent equals the marginal benefit at each number of hours Figure (b) shows the MB curve: note how the MB varies with the number of hours Marginal benefit curve is described by the function MB(H)= 654-80H
3-31

Relationship between Total Benefit and Marginal Benefit

(a): Total Benefit (b): Marginal Benefit
Slope = MB = 254
Total Benefit ($) Marginal Benefit ($/hour)

(Figure 3.5)

Slope = MB = 414
654 2270

B Slope = MB = 574
1602

574

414

MB
254

614

Hours (H)

Hours (H)

3-32

Relationship between Total Cost and Marginal Cost

Parallels relationship between total benefit curve and marginal benefit When actions are finely divisible, the marginal cost when choosing action X is equal to the slope of the total cost curve at X Using Calculus

dC H MC H dH

3-33

Relationship between Total Cost and Marginal Cost

Tangents to the total cost curve at three different numbers of hours (H = 1, H = 3, H = 5) Slope of each tangent equals the marginal cost at each number of hours Figure (b) shows the MC curve: note how the MC varies with the number of hours Marginal cost curve is described by the function MC(H)= 110+80H
3-34

Relationship between Total Cost and Marginal Cost

(Figure 3.6)
(a): Total Cost (b): Marginal Cost
Total Cost ($) Marginal Cost ($/hour)

C MC

1550

510

350

Slope = MC = 510 Slope = MC = 190

690 190

110

Slope = MC = 350
150

3 Hours (H)

3 Hours (H)

3-35

Using Calculus to find Best Choice

Net Benefit = Total Benefit Total Cost Maximize Net Benefit (NB(H)). Using Calculus;
dNBH dBH dC H 0 dH dH dH dBH dC H MBH MC H dH dH

Using Calculus to find Best Choice

So, at the maximum; MB(H) = MC(H). MB(H)= 654-80H MC(H)= 110+80H Solving, we obtain H* = 3.4.

Marginal Benefit Equals Marginal Cost at a Best Choice

At the best choice of 3.4 hours, the No Marginal Improvement Principle holds so MB = MC At any number of hours below 3.4, MB > MC, so a small increase in repair time will improve the net benefit At any number of hours above 3.4, MC > MB, so that a small decrease in repair time will improve net benefit
3-38

Marginal Benefit Equals Marginal Cost at a Best Choice (Figure 3.7)

Marginal Benefit, Marginal Cost ($/hour) 654

MC

382

MB

110

2 Hours (H)

3 3.4

3-39

Slopes of Total Benefit and Total Cost Curves at the Best Choice
MC = MB at the best choice of 3.4 hours of repair Therefore, the slopes of the total benefit and total cost curves must be equal at this point Tangents to the total benefit and total cost curves show this relationship
3-40

Slope of Total Benefit and Total Cost Curves

(Figure 3.8)
Total Benefit Total Cost ($)

924.80

2 Hours (H)

3 3.4

3-41

Sunk Costs and Decision Making

A sunk cost is a cost that the decision maker has already incurred, or A cost that is unavoidable regardless of what the decision maker does. Sunk costs affect the total cost of a decision Sunk costs do not affect marginal costs So sunk costs do not affect the best choice
3-42

Car Repair Example: Best Choice with a Sunk Cost

Figure 3.9 shows a cost-benefit comparison for two possible cost functions with sunk fixed costs: $500 and $1100. In both cases, the best choice is H = 3.4: the level of sunk costs has no effect on the best choice Notice that the slopes of the two total cost curves, and thus the marginal costs, are the same
3-43

Best Choice with a Sunk Cost

(Figure 3.9)

Total Benefit, Total Cost ($) -175.20

B C

424.80 1100

500

2 Hours (H)

3 3.4

3-44