Marginal Thinking

“Is it worth it?”

The Margin

Is it worth it?A thing worth doing may not be worth doing well. Know when it’s time to move on!Look forward, not back!When is enough enough?

MARGINAL

• Additional, difference• What is the marginal benefit between a regular

order of fries and a giant order of fries? What is the marginal opportunity cost?

• What is the marginal benefit of an additional 15 minutes of sleep? What is the marginal opportunity cost?

• Marginal benefit/marginal cost analysis compares the additional benefit of another unit of the product or activity to the additional opportunity cost.

Unfortunate consequences of scarcity

• You will never be the best parent you could be.

• You will never be the best student you could be.

• You will never be the best spouse you could be.

• I will never be the best teacher I could be.• Maximize your LifePointAverage, when

working on your GPA!

Using Marginal Benefit/Marginal Cost Analysis

• Investigating two alternatives• What’s the difference in benefits between the

two?• What’s the difference in opportunity cost

between the two?• Is the marginal benefit of the choice greater

than the marginal opportunity cost?• Is this the best use of additional resources?

What is the benefit and what is the opportunity cost?

• How good a parent are you? – Your daughter has a hockey game and

your boss has called n “emergency” meeting. (MB and MOC)

• How good a student are you? – You have a test tomorrow and your boss

says she needs you at work. (MB and MOC)

What is the benefit and what is the opportunity cost?

• How good a spouse are you? – Your wife wants you to go to her mother’s

with her but you really need to write the term paper. (MB and MOC)

• How good a teacher will I be?– I want to prepare a lesson plan but my son

is asking for help with algebra. (MB and MOC)

Marginal Analysis•

We try to make the best use of our scarce resources by using them in particular activities (work, parenting, spousing) as long as the marginal benefit is greater than the marginal opportunity cost.

• We attempt to maximize our Life Point Average, not just our GPA or our income, or any other single goal. We try to do our best with the “basket” of goals.

Cleaning the brown lake

• The lake is dirty.

• Let’s clean it.

• How clean?

• What are the benefits of different degrees of clean?

• What is the marginal opportunity cost?

The relevant questions

• If I put one more hour of human capital into studying,– what difference will it make to my grade

(benefit), and– what difference will it make to my children

in the short run (cost)?

• Is the additional studying the best use of my limited human capital, based on my estimates of net benefit?

Juan or George?

Marginal Analysis –What’s the difference?

• Marginal is the change the results from a little more or a little less of an activity

• When comparing two alternatives – what is the marginal benefit and the marginal opportunity cost of both alternatives?

• You only use marginal analysis when comparing two alternatives.

• Is the marginal benefit worth what I will be giving up?

Marginal Opportunity CostHershey’s or Hershey’s with Almonds

• A • B•C

•Chocolate

•More chocolate•Almond

s

Marginal Opportunity Cost

• A • B•C

Marginal Opportunity Cost

• A • B•C

The Marginal Principle

• How far should I pursue any single activity, knowing that the resources I am using have opportunity costs; they could be doing other things?

• If

Round 1 Round 2 Round 3 Round 4 Round 5

$1.50

$1.00

•MC

•MB

Marginal benefit – marginal cost

Round 1 Round 2 Round 3 Round 4 Round 5

$1.50

$1.00

•MC

•MB

Marginal benefit – marginal cost

Round 1 Round 2 Round 3 Round 4 Round 5

$1.50

$1.00

$1.45

$1.20

•MC

•MB

Marginal benefit – marginal cost

Round 1 Round 2 Round 3 Round 4 Round 5

$1.50

$1.00

$1.45

$1.20

$1.35

$1.25

•MC

•MB

Marginal benefit – marginal cost

Round 1 Round 2 Round 3 Round 4 Round 5

$1.50

$1.00

$1.45

$1.20

$1.35

$1.25

$1.32

$1.27

•MC

•MB

Marginal benefit – marginal cost

Round 1 Round 2 Round 3 Round 4 Round 5

$1.50

$1.00

$1.45

$1.20

$1.35

$1.25

$1.32

$1.27

$1.30

$1.29

•MC

•MB

Marginal benefit – marginal cost

Round 1 Round 2 Round 3 Round 4 Round 5

$1.50

$1.00

$1.45

$1.20

$1.35

$1.25

$1.32

$1.27

$1.30

$1.29

•MC

•MB

Marginal benefit – marginal cost

How many rounds to play?

RoundRound 11 22 33 44 55 66

Marginal Marginal BenefitBenefit

$1.5$1.500

$1.4$1.455

$1.3$1.355

$1.32$1.32 $1.30$1.30 $1.2$1.255

Marginal Marginal OpportunitOpportunity Costy Cost

$1.0$1.000

$1.2$1.200

$1.2$1.255

$1.27$1.27 $1.29$1.29 $1.3$1.355

Marginal Marginal Net GainNet Gain

$.50$.50

Total GainTotal Gain $.50$.50

How many rounds to play?

RoundRound 11 22 33 44 55 66

Marginal Marginal BenefitBenefit

$1.5$1.500

$1.4$1.455

$1.3$1.355

$1.32$1.32 $1.30$1.30 $1.2$1.255

Marginal Marginal OpportunitOpportunity Costy Cost

$1.0$1.000

$1.2$1.200

$1.2$1.255

$1.27$1.27 $1.29$1.29 $1.3$1.355

Marginal Marginal Net GainNet Gain

$.50$.50 $.25$.25

Total GainTotal Gain $.50$.50 $.75$.75

How many rounds to play?

RoundRound 11 22 33 44 55 66

Marginal Marginal BenefitBenefit

$1.5$1.500

$1.4$1.455

$1.3$1.355

$1.32$1.32 $1.30$1.30 $1.2$1.255

Marginal Marginal Opportunity Opportunity CostCost

$1.0$1.000

$1.2$1.200

$1.2$1.255

$1.27$1.27 $1.29$1.29 $1.3$1.355

Marginal Marginal Net GainNet Gain

$.50$.50 $.25$.25 $.10$.10 $.05$.05 $.01$.01 -$.10-$.10

Total GainTotal Gain $.50$.50 $.75$.75 $.85$.85 $.90$.90 $.91$.91 $.81$.81

How much of a particular activity? Know when to move

on.• Pursue activities as long as the marginal benefit

exceeds the marginal opportunity cost.• Pursue activities up to the point where

MB = MOC.• If the marginal benefit of another unit of the

activity is greater than the marginal opportunity cost, go for it!

• If the marginal benefit of another unit of the activity is less than the marginal opportunity cost, stop!

The Marginal Principle: Pursue all activities up to the

point where:

Marginal Principle

• MB greater than MOC, go for

it!

• MB less than MOC, go back;

you have gone too far.

Marginal Analysis in Allocating Society’s

Resources

•(1)(1)

•AlternativeAlternative

•(2)(2)

•Penalty Penalty for for

carryingcarrying

•(3)(3)

•Penalty Penalty for for

displayingdisplaying

•(4)(4)

•New New beds beds

neededneeded

•(5)(5)

•Total Total Cost Cost

($mil)($mil)

•(6)(6)

•Marginal Marginal Cost Cost

($mil)($mil)

•1

•2

•3

•5

•3

•5 •10

•6

•4700

•4200

•123 •$6.2

•$210

•$235

•$6.2

•$203.8

•$228.8•4

•0•0 •0

•5

•0 •--

Marginal Value of PenaltiesMarginal Value of Penalties

Where to spend $10 million?

Air Ground Water

Alternative 1 50% 100% 25%

Alternative 2 48% 95% 90%

Alternative 3 5% 10% 100%

I’m soft on crime

Benefit Cost

1 Three Strikes 10% $50 mill

2 Stricter Enforce 8% $25 mill

ment

3 Address social 50% $55 mill

issues

How much safety?

•Cars?

•Airport security?

•Civil liberty?

•Education •Average Income

•Marginal Income

•Not High School Grad

•High School Graduate

•Associate

•4 yr College Graduate

•Master’s

•Doctorate

•Professional

•18,226

•27,280

•34,177

•51,194

•60,445

•89,734

•112,845

•9,054= 50%

•

Education

•Source: U.S. Census Bureau, Statistical Abstract of the U.S. 2004-2005

•Education •Average Income

•Marginal Income

•Not High School Grad

•High School Graduate

•Associate

•4 yr College Graduate

•Master’s

•Doctorate

•Professional

•18,226

•27,280

•34,177

•51,194

•60,445

•89,734

•112,845

•9,054= 50%

• 6,897 = 25%

Education

•Source: U.S. Census Bureau, Statistical Abstract of the U.S. 2004-2005

•Education •Average Income

•Marginal Income

•Not High School Grad

•High School Graduate

•Associate

•4 yr College Graduate

•Master’s

•Doctorate

•Professional

•18,226

•27,280

•34,177

•51,194

•60,445

•89,734

•112,845

•9,054= 50%

• 6,897 = 25%

•17,017 = 50%

•

Education

•Source: U.S. Census Bureau, Statistical Abstract of the U.S. 2004-2005

•Education •Average Income

•Marginal Income

•Not High School Grad

•High School Graduate

•Associate

•4 yr College Graduate

•Master’s

•Doctorate

•Professional

•18,226

•27,280

•34,177

•51,194

•60,445

•89,734

•112,845

•9,054= 50%

• 6,897 = 25%

•17,017 = 50%

• 9,251 = 18%

Education

•Source: U.S. Census Bureau, Statistical Abstract of the U.S. 2004-2005

•Education •Average Income

•Marginal Income

•Not High School Grad

•High School Graduate

•Associate

•4 yr College Graduate

•Master’s

•Doctorate

•Professional

•18,226

•27,280

•34,177

•51,194

•60,445

•89,734

•112,845

•9,054= 50%

• 6,897 = 25%

•17,017 = 50%

• 9,251 = 18%

•29,289 = 48%

Education

•Source: U.S. Census Bureau, Statistical Abstract of the U.S. 2004-2005

•Education •Average Income

•Marginal Income

•Not High School Grad

•High School Graduate

•Associate

•4 yr College Graduate

•Master’s

•Doctorate

•Professional

•18,226

•27,280

•34,177

•51,194

•60,445

•89,734

•112,845

•9,054= 50%

• 6,897 = 25%

•17,017 = 50%

• 9,251 = 18%

•29,289 = 48%

•23,111 = 26%

Education

•Source: U.S. Census Bureau, Statistical Abstract of the U.S. 2004-2005

How much education and training is right for you?

• High school• High school plus vocational training• Two year college degree• Four year college degree• Etc.• The rule: Continue your education as long as

the marginal benefit of additional education is greater than the marginal opportunity cost of additional education.

The problem

• The rule is simple.

• The estimates of marginal benefit and marginal cost is not. – The estimates are of future benefits and

costs.– Most of us are not very good at predicting

the future

Sunk Cost

•

                               

                              

•You got to know when to hold ‘em

•Know when to fold ‘em

•Know when to walk away

•And know when to run

SUNK COSTS vs.MARGINAL COST

• SUNK COSTS (backward looking – irrelevant)

•MARGINAL COSTS

•(the consequences of choices lie in the future - only relevant costs)

Whiteout!What is the marginal

benefit of your being there for the next three days?

What is the marginal benefit of the best alternative?

What should you do?

No Surf!What is the marginal

benefit of staying for the next six hours?

What is the marginal benefit of the best alternative?

What should you do?

A terrible movie What is the marginal

benefit of staying there for the next two hours?

What is the marginal benefit of the best alternative?

What should you do?

A horrible marriage?What is the marginal

benefit of staying with the bum for the next fifty years?

What is the marginal benefit of the best alternative?

What should you do?

Use marginal analysis to explain why you don’t want to

join the “Clean Plate Club.”

Was there any mention of “sunk costs” in any of these

decisions?• Skiing

• Surfing

• Watching a movie

• Marriage

SUNK COSTS

• You have no control over sunk costs so they are not part of the decision-making process

SUNK COSTS vs.MARGINAL COST

• SUNK COSTS (backward looking – irrelevant)

•MARGINAL COSTS

•(the consequences of choices lie in the future - only relevant costs)

•The past is gone; you can do nothing about it. The present is now. The future is determined by your decisions now. Consider those things that you can control, not those that you can’t.

Marginal Analysis is Forward Looking; Sunk Costs are

Irrelevant.• I paid for this ticket, I’m going to sit here

whether I enjoy it or not.• I have to fix the transmission; I just bought $500

worth of tires.• I have to stay with my husband; I’ve put 23

years into this marriage.• I paid for this dessert; I have to eat it all. • Even though this school is built on top of a

contaminated site, we have to continue construction; we’ve already put $2 million into it!

Main Points

• Marginal benefit is the addition to total benefits from one more unit of an activity.

• Marginal cost is the addition to total cost of one more unit of an activity.

• Every economic decision has a marginal benefit and a marginal cost.

• Marginal analysis always identifies the differences between two alternatives.

Main Points

• Marginal analysis compares the marginal benefits with the marginal opportunity costs of two alternatives.

• The marginal principle states that the use of a resource should be continued if the marginal benefit of additional use of the resource is greater than the marginal opportunity cost and should be discontinued if the opposite is true. MB greater than MOC, continue; MB less than MOC, stop.

Main Points

• Estimations of marginal benefits and marginal opportunity costs are subjective and difficult.

• Sunk costs are irrelevant. A decision maker compares the marginal benefit and marginal opportunity costs of the best two alternatives.