Quick recap

What is microeconomics?
Limited resources and market
Demand
Supply
Market equilibrium
Elasticity

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

3-3

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 next best alternative use
Right decision is the choice with the
greatest difference between total benefit
and total cost
3-4

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)

Total Benefit
($)

615

1150

1600

1975

2270

2485
3-5

Car Repair Example:

Cost Schedule
Table 3.2: Costs of Repairing Your Car
Repair
Time
(Hours)

Cost of Mechanic and

Parts
($)

Lost Wages from

Pizza Delivery Job
($)

Total
Cost
($)

140

10

150

355

25

380

645

45

690

1005

75

1080

1440

110

1550

1950

150

2100

3-6

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
3-7

Car Repair Example:

The Right Decision
Table 3.3: Total Benefit and Total Cost of
Repairing Your Car
Repair Time
(Hours)

Total Benefit
($)

Total Cost
($)

615

150

1150

380

1600

690

1975

1080

2270

1550

2485

2100

Net Benefit
($)

3-8

Car Repair Example:

The Right Decision
Table 3.3: Total Benefit and Total Cost of
Repairing Your Car
Repair Time
(Hours)

Total Benefit
($)

Total Cost
($)

Net Benefit
($)

615

150

465

1150

380

770

1600

690

910

1975

1080

895

2270

1550

720

2485

2100

385

3-9

Car Repair Example:

The Right Decision
Table 3.3: Total Benefit and Total Cost of
Repairing Your Car

Best
Choice

Repair Time
(Hours)

Total Benefit
($)

Total Cost
($)

Net Benefit
($)

615

150

465

1150

380

770

1600

690

910

1975

1080

895

2270

1550

720

2485

2100

385

3-10

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

910

1200

800

400

465

Repair
Hours

Best Choice

3-11

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 we 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
3-12

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)

3-13

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)

3-14

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

3
Hours
(H)

3.4

3-15

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

3
Hours (H)

3.4

3-16

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 X units, where X is the
smallest amount you can add or subtract
3-17

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

C C ( X ) C ( X X )

X
X

3-18

Car Repair Example:

Marginal Cost
Marginal cost measures the additional
cost incurred from the marginal units (H)
of repair time
If C(H) is the total cost of H hour of repair
work, the extra cost of the last H hours is
C = C(H) C(H-H)
To find marginal cost, divide this extra cost
by the number of extra hours of repair
time, H
3-19

Car Repair Example:

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

H
H

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

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

3-20

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)

150

150

380

230

690

310

1080

390

1550

470

2100

550

3-21

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
MB

B B(X) B(X X)

X
X

3-22

Car Repair Example:

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

3-23

Car Repair Example:

Marginal Benefit
The marginal benefit of an additional hour of
repair time is:
B B(H) B(H H)
MB

H
H

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

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

3-24

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)

615

615

1150

535

1600

450

1975

375

2270

295

2485

215

3-25

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
3-26

Marginal Analysis and Best

Choice
Table 3.7: Marginal Benefit and Marginal
Cost of Repairing Your Car

Best
Choice

Repair
Time
(Hours)

Marginal
Benefit (MB)
($/hour)

Marginal
Cost (MC)
($/hour)

615

>

150

535

>

230

450

>

310

375

<

390

295

<

470

215

<

550

3-27

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
3-28

Marginal Benefit
Using Calculus

dB H
MB H
dH
This is the slope of the Total Benefit
Curve B(H).

Car Repair Example:

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

3-30

Relationship between Total

Benefit and Marginal Benefit

(Figure 3.4)

Total
Benefit
($)

Slope = MB

B( H )

Slope = MB = B' / H'

B' '

B( H H' ' )
B'

B( H H' )

H H'

Slope
= MB = B' ' / H' '

H H' '

H
Hours (H)

H' '
H'

3-31

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
3-32

Relationship between Total

Benefit and Marginal Benefit

(Figure 3.5)

(b): Marginal Benefit

(a): Total Benefit

Slope = MB = 254

Total
Benefit ($)

Marginal Benefit
($/hour)

Slope = MB = 414
654
2270

574

Slope = MB = 574
1602
414

MB
254

614

3
Hours (H)

Hours (H)

3-33

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

3-34

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
3-35

Relationship between Total Cost

and Marginal Cost
(Figure 3.6)

(a): Total Cost

(b): Marginal Cost

Marginal Cost
($/hour)

Total Cost
($)

C
MC
510

1550

350

Slope = MC = 510
Slope = MC = 190
690

190

110

Slope = MC = 350
150

3
Hours (H)

Hours (H)

3-36

Using Calculus to find Best

Choice
Net Benefit = Total Benefit Total Cost
Maximize Net Benefit (NB(H)).
Using Calculus;
dNB H dB H dC H

0
dH
dH
dH
dB H dC H

MB H 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
3-39

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)

3.4

3-40

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
3-41

Slope of Total Benefit and Total

Cost Curves
(Figure 3.8)

Total
Benefit
Total
Cost
($)

924.80

3
Hours (H)

3.4

3-42

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
3-43

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
3-44

Best Choice with a Sunk Cost

(Figure 3.9)

Total
Benefit,
Total Cost
($)

B
-175.20

424.80
1100

500

3
Hours (H)

3.4

3-45