X. MARGINAL ANALYSIS AND MAXIMIZING NET BENEFITS
Decisions in economics are not really all that different from other decisions. Sometimes decisions are analyzed using Pro's and Con's. That is all we are doing with Net Benefits or Benefits minus Costs. These are Pro's and Con's with some numerical values attached to each Pro to get the benefits and other numerical values attached to the Con's. If you recall that costs (opportunity costs) are highest benefits foregone from a particular action, then net benefits are the benefits gained minus the benefits lost. The analysis used here is presented in a general fashion, that is, we may use the same basic analysis when maximizing profit, utility, net social benefits, or even minimizing costs.
As we saw in the previous section, marginal "anything" is the additional "anything" from an additional unit of some action. The marginal benefits of consuming gasoline are the added benefits you receive from consuming one more unit of gasoline. The marginal costs of consuming gasoline are the additional costs you incur from consuming one more unit of gasoline. These costs may be monetary or they may be in other terms (utility, for instance). For the analysis, benefits and costs must be measured in the same units.
Most of the time we find that marginal benefits fall as we do more of something, that is, the first unit of the activity x (consumption, production, etc.) adds more benefits than the one hundredth unit than the one thousandth unit and so on. For example, the first gallon of gasoline we consume per year adds more to our benefits than the one thousandth, because if we only had one gallon of gasoline per year, we would save that gallon for the most important uses. The thousandth gallon would not be put to uses that were as important as that single unit would be.
Most of the time we find that marginal costs tend to rise as we do more of something. The first unit of activity x will mean we may have to give up the thousandth unit of something else, z, (low benefits lost), whereas the thousandth unit of x may mean we have to give up the first unit of z (higher benefits lost). Marginal production costs eventually rise as well. The first unit adds less to our costs than the thousandth unit.
What this means is that over some range early on in the activity
(the first few units), one more unit of activity x adds more to
benefits than it adds to costs (MBx > MCx).
As long as an additional unit of activity x adds more to benefits
than it adds to costs, one's situation (in terms of net benefits)
is improved by increasing activity x. If marginal costs
are increasing and marginal benefits are decreasing with increased
units of x and marginal benefits were first greater than marginal
costs, then eventually marginal benefits and marginal costs will
cross. That is, marginal benefits at some point will equal
marginal costs and more x will cause marginal costs to exceed
marginal benefits. If marginal costs are greater than marginal
benefits, then additional units of x will cause net benefits to
decline. If marginal costs are equal to marginal benefits,
then a little more x neither causes marginal benefits to rise
or to fall.
What has just been shown is that net benefits are greatest where
marginal costs equal marginal benefits if marginal costs are below
marginal benefits just before the two cross. If marginal
costs are first greater than marginal benefits and we increase
the activity until marginal costs and marginal benefits are equal,
we keep adding more to our costs than to our benefits, reducing
our net benefits.
Rule: Pursue an activity until marginal costs equal marginal
benefits, as long as marginal costs cut marginal benefits from
below.
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