Principle 4: People usually decide at the margin (Give a little; get a little)
Objectives:
Distinguish total decisions from marginal decisions
Use the marginal principle in decision-making
Identify two decisions (past and future) when considering sunk cost
Why do you want to learn this? More informed decision maker
A story: Jorge and Myesha were newlyweds. They were excited about setting up their house and getting furniture and appliances. (They had been saving for this for about six years.) They found a dishwasher they liked and it was not too expensive. Looking at the additional features that they could buy, Myesha thought that the flat rack on the top would be handy for plastic container tops and probably lots of other stuff. It was only an additional $100. Jorge wasn’t so sure but agreed to get it. (He was thinking goal – nice furniture and nice appliances, financial resources - $100, alternatives – extra dishwasher rack or nicer couch. Their choice was using the $100 for the flat rack, the opportunity cost was the additional quality of the couch. They had the dishwasher delivered and ran it a couple of times before they realized that the things on the top rack didn’t really get clean. They never used it again. Ouch! Had they researched their alternatives a bit more carefully and applied marginal analysis, they might have made a more informed decision. Marginal analysis can make you smarter consumers, improve your relationships, provide you with peace of mind, and so many other things. So here we go!
The margin should be a pretty easy concept because we use it all the time. What time will you go to bed tonight and what time will you get up tomorrow morning? In other words, how much sleep will you get? There is a concert that you want to see but the ticket price for the “pit” is $300. How much are you willing to spend? You are getting a new laptop. How much memory do you want and how much are you willing to spend on memory and other stuff? You are getting a soft drink at the minimart. Small size or Giant size?
Marginal vs. Total
The table below uses the examples above to distinguish total decisions from marginal decisions.
Total | Marginal | |
Sleep | Sleep or don’t sleep | How much to sleep |
The concert | Go or don’t go | How close to the stage |
The laptop | Buy a laptop or don’t buy a laptop | How much memory and other stuff are you willing to pay for |
Soft drink | Get a soft drink or don’t | What size soft drink? |
We discussed Alaskan land earlier. Some oil companies want to drill in the Alaskan wilderness that is owned by the federal government. It is probably not the case that all of the Alaskan wilderness will be used for oil exploration, so the question is how much will be used for exploration. Now we are in a balancing act, how much wilderness will we give up and how much benefit do we expect to gain from the exploration? As soon as we begin asking how much, we get into the realm of the margin. In economics, margin means a little more or a little less. In the example above Myesha and Jorge gave up a little couch quality to get a little more dishwasher. They gave a little to get a little.
You are getting ready for a date and you are washing your car. It’s getting late and you haven’t showered or done what is necessary to make yourself presentable. Do you scrub the tires? If so, what is the marginal opportunity cost? If scrubbing the tires means that you shower but don’t shave or do a great makeup job, is scrubbing the tires a good choice? How clean do you get the car and how groomed do you get? These are marginal decisions. You are not asking whether you should wash the car and clean yourself up, you are asking how clean you get the car and how clean you get you. How much Alaskan wilderness do we give up for oil exploration and how much do we preserve?
Let’s take another example. There is a concert in town that you want to attend. Tickets range from $240 to $600. Here are the ticket prices and your evaluation of how much it is worth to be closer for each price range. Here is the problem. Your parents have told you that they will buy you a car, your aunt’s old Chevy. She wants to get rid of it and has offered it at a very reasonable price. But you are responsible for the insurance. No insurance, no car. So you have been saving
Location | Price (total cost) | Marginal Cost | Marginal Value of closer seats | Additional weeks waiting |
Sec 4 (far away) | $240 | 6 | ||
Sec 3 (closer) | $320 | $80 | $120 | 2 |
Sec 2 (closer) | $440 | $120 | $75 | 3 |
Sec 1 (closest) | $600 | $160 | $65 | 4 |
for the insurance and you have $250 put away. Your aunt is willing to wait a bit until you can get the insurance money but she is not willing to wait forever. The tickets to the concert will have to come out of your saving which means you will have to wait longer to get the car. You work one night per week and you take home $40 per night. So where do you sit at the concert? You are definitely going to go so that will cost you about six week’s additional waiting for the car. ($240/$40 = 6 weeks) But now the question is where you will sit. If you move from Section 4 to Section 3, it will cost you an additional $120 or 3 weeks more waiting for the car. If you move from Section 3 to Section 2, it will cost you an additional $120 or 3 more weeks. Section 2 to Section 1 (the best seats in the house) will cost you an additional $160 or 4 more weeks. That car is getting farther and farther away and your aunt will become less and less patient!
The 4th column (marginal value of closer seats) includes your subjective evaluation of the better seats. These are estimates and they belong only to you. So, once again, where do you sit? If the marginal (additional) value of closer seats is greater than the marginal (additional) opportunity cost (the additional wait for the car), then you should buy the better seats. So starting with section 4, should you move to Section 3 for an additional $80? Sure. The additional cost of moving from 4 to 3 is 2 more weeks waiting for the car and you estimate that the value of the better seat is $120. It’s worth it to you to buy the more expensive seats. MB is greater than MC. Should you move down to Sec 2? No, the MB of moving from 3 to 2 is $75 and the MC is $120. It is not worth it to you. So you pay $320 for a seat in Section 3. You have a great time at the concert but your aunt loses patience, donates the car to a charity, and uses it as a tax deduction. Bummer. Who knew?
Here is the point. Every choice has benefits and a cost. When we are trying to decide how much of an activity to do, it is helpful to identify the opportunity cost of your choice and then decide how much of that activity you are willing to give up to get what you want. How much are you willing to pay (increased waiting time for the car) for better seats at the concert? How clean do you want to get the car and how much of your grooming are you willing to give up?
The marginal principle states that an activity should be continued as long as the marginal benefit from the additional activity is greater than the marginal opportunity cost. This applies to personal decisions, decisions at your school or city or town and decisions at the national level. How many resources should we devote to immigration control, given that those resources could be used for infrastructure repair? How many resources should be devoted to F-35 Joint Strike Fighter jets, given that those resources could be used to provide housing for the homeless? In order to make these decisions we have to have some idea of the marginal benefits from a certain amount of jets and how much we give up by not using those resources for housing the homeless. While individual citizens don’t usually have that information, we trust our elected officials to make the decisions. It is important for us, as citizens, to ensure that the questions concerning marginal benefits and marginal costs are asked.
Another example
It is 8 o’clock at night and you have a history test and an econ test tomorrow. In order to get your required beauty sleep, you must go to bed at 11 PM and be up by 6 AM to get to school on time. If you want to do well you will have to study. You could use all of your human capital on the econ exam and hope you do well on the history exam or vice versa. That would be an all and nothing decision; you would be gaining the study for the econ exam and paying an opportunity cost – studying for the history exam. But you don’t feel confident enough to let either one slide, you want to study a bit for both. That is a marginal decision; do a bit more of one, and a bit less of another. Marginal decisions involve gaining some of one thing/activity and giving up some of another thing/activity; gaining a marginal benefit and paying a marginal opportunity cost.
4 steps to understanding marginal analysis.
You can’t have everything you want. Scarcity exists.
When you choose one alternative and give up another, you pay an opportunity cost.
When you choose some of one alternative and give up some of another alternative, you are making a marginal decision, paying a marginal opportunity cost.
If you could accurately measure the incremental benefits and opportunity costs of different combinations of the two alternatives, you would be using your scarce resources as efficiently as possible to reach your goals, in the example above a good grade on both tests.
Implications
If a thing is worth doing, it may not be worth doing well.
You will never be the best student/athlete/video gamer/boyfriend-girlfriend you could be because every one of these activities has an opportunity cost. You have to choose how much of your human capital to put into each of these roles.
Since resources have alternative uses, pre-school education competes with elementary, middle, high school, and college education for scarce resources. Given limited resources, if society puts resources into pre-school education, elementary, middle, high school and college suffer. The key is to use marginal analysis to calculate the best combination of the five, realizing that, because of scarcity and marginal opportunity cost, no one type will be the best that it could be.
Any time you use a resource that has alternative uses, marginal benefit marginal cost analysis can help you balance the competing demands on the resource.
Sunk cost
You’ve got to know when to hold them, know when to fold them, know when to walk away and know when to run.
You are sitting at a sports event and you and your date are bored, very, very bored. Your team is down by a lot, and it doesn’t look like there is much hope. You paid a lot for the tickets. Do you stay to the end in hopes of a comeback or do you cut your losses and go to the café around the corner for a quick meal and some “quality time” with your date? You won’t be able to get your money back. There are two decisions involved. The first was the decision you made when you decided to buy the tickets instead of whatever you would have done with the money. The cost of choosing to buy the tickets is now a sunk cost -- a cost which is in the past and irretrievable. Your anticipated advantages of going to the game were incorrect. An unanticipated consequence of purchasing the tickets is that the game stinks. Now it is time to make a second decision. How are you going to use your human capital to make the best of the rest of the day? Your two alternatives now are to stay at the rotten game and be bored and angry or leave and go have an enjoyable meal with your date. Which alternative is the best use of your human capital? It doesn’t make sense to look to the past which you can’t change but to look to the future where you have alternatives. Marginal analysis allows you to ask the question, “How much more of our human capital should we use here in hope? How much more human capital should we devote to the game and how much to the best alternative?” Marginal analysis tells you to look to the future which you can control as opposed to the past which you can’t control. Look forward, not back. The fact that you have devoted much of your human capital to an activity is no reason to continue “wasting” your human capital if the marginal benefit of the alternative is greater than the marginal opportunity cost.
Marginal decisions vs. total decisions.
In the example above, the couple is trying to decide how much of their human capital to spend at the game and how much of their human capital to take to dinner. How long should they stay at the game in hopes of a miracle? “Well, let’s just stay for one more inning.” That is a marginal decision. Any time you hear the question, “How much?” you know you are looking at a marginal decision. If the question is “This or that?” you are looking at a total decision.
Bottom Line:
Scarcity tells us that we can’t have everything we want.
Every choice has a cost.
Whenever we ask “how much” in reference to the use of a resource, we are using marginal analysis.
Marginal benefit is the addition to total benefits from one more unit of an activity.
Marginal opportunity cost is the addition to total opportunity cost from one more unit of an activity.
The marginal principle states that an activity should be continued as long as the marginal benefit from the activity is greater than the marginal opportunity cost.
Estimation of marginal benefits and marginal opportunity costs are subjective.
While the benefits and costs are difficult to measure, we have to at least ask the questions. How many resources are we devoting to this activity, what do we expect the benefits to be, and what are we giving up to do this? Is this the best use of our resources, given that every choice has an opportunity cost?
Sunk cost is irrelevant. Look to the future, not the past. Is the marginal benefit of using your human capital to read one more chapter of a book greater than the marginal opportunity cost of reading the first chapter of another book that you think you are going to like?
Questions:
1. Which of the following is a marginal decision?
a. Using the car to go to a game or to go to a movie
b. Using your human capital to study for two hours and sleep for six, or study for one hour and sleep for seven hours
c. Using your human capital to get a job after graduation or attend a community college
d. Paying cash or using a credit card to buy a shirt
2. Which of the following is a marginal decision? Going to the gym
a. or texting your friends
b. for an hour and texting your friends for 45 minutes
c. or staying home and watching TV
d. or jogging around your neighborhood
3. If enlightened policymakers decide to reduce the resources dedicated to maintaining trails in our national forests when the opportunity cost of maintaining the trails is reduced preservation of endangered species, the decision could be justified if the marginal benefits of maintaining the trails were:
a. declining
b. less than the total benefits
c. less than the average opportunity cost of caring for the animals
d. less than the marginal opportunity cost of caring for the animals
4. We will never have the quality of health care that we could have because we know for certain that:
a. there is a level of health care beyond which the benefits from additional units of health care are less than the benefits from additional units of the best alternative use of the resources.
b. devoting resources to health care involves an opportunity cost.
c. the marginal benefit of health care is less than the marginal benefit of public safety.
d. policy makers in general do not understand marginal analysis or choose to ignore it.
5. The cost of a decision made in the past is a(n):
a. Transaction cost
b. Sunk cost
c. Average cost
d. Search cost
6. You are upset because you ordered a meal at a restaurant and it is lousy; just the smell almost makes you sick. In which of these circumstances would an economist bring the rest of the meal home to eat later?
a. She paid $5 for the meal
b. She paid $25 for the meal
c. She paid $150 for the meal
d. Never
You have $50 to spend on jewelry. You see a necklace that you like which is priced at $50. There is another that is priced at $30, which would leave you with enough to buy a bracelet for $20. Your friend says that the $50 necklace will make a statement but you can’t see the difference between the two bracelets. Is the more expensive bracelet worth the additional $20? Use marginal benefit marginal opportunity cost analysis to explain to your friend why you are buying the less expensive bracelet.
Marginal opportunity cost
How much study and how much work
How much environment and how much fossil fuels
How much save and how much spend – budgeting
How many elephants and how many villagers
How much trail maintenance and how much visitor information