Marginal analysis

Opportunity Cost, Marginal Analysis, Rationalism

Opportunity CostoOpportunity cost is the benefit forgone from the alternative that is not selected.

oOpportunity cost can be defined as the cost of any decision measured in terms of the next best alternative, which has been sacrificed.

oTo illustrate the concept better, let us assume that a person who has Rs. 100 at his disposal can spend it on either of the three options:

oa) having a dinner at a restaurant,

ob) going for a music concert or

oC) for a movie.

oThe person prefers going for a dinner rather than to the movie, and the movie over the music concert. Hence, his opportunity cost is sacrificing the movie, the next best alternative once he goes for a dinner.

oIf we carry forward the same example at the firm level, a manager planning to hire a stenographer may have to give up the idea of having an additional clerk in the accounts department.

oThis is applicable even at the national level where the country allocates higher defense expenditures in the budget at the cost of using the same money for infrastructural projects. In order to maximize the value of the firm, a manager must view costs from this perspective

Marginalism oIf resources at disposal of a manager are scarce,

he has to be careful about the utilization of each and every additional unit of resources. In order to decide on the use of an additional man-hour or machine-hour, he needs to know what is the additional output expected therefrom.

oSimilarly, a decision about additional investment has to be taken in view of the additional return from that investment.

oThe term ‘marginal’ is relevant for all such additional magnitudes of output or return

Marginal valueThe marginal value of a dependent variable is the change in this dependent variable associated with a 1-unit change in a particular independent variable

Marginal AnalysisMarginal analysis is used to assist people in allocating their scarce resources to maximize the benefit of the output produced.

Simply getting the most value for the resources used.

Marginal AnalysisMarginal analysis: The analysis of

the benefits and costs of the marginal unit of a good or input.

(Marginal = the next unit)

Marginal AnalysisA technique widely used in business

decision-making and ties together much

of economic thought.

In any situation, people want to maximize net benefits:Net Benefits = Total Benefits - Total Costs

The Control VariableTo do marginal analysis, we can change a

variable, such as the:

o quantity of a good you buy, othe quantity of output you produce, oro the quantity of an input you use.

This variable is called the control variable .

The Control VariableMarginal analysis focuses upon

whether the control variable should be increased by one more unit or not.

Key Procedure for Using Marginal Analysis

1. Identify the control variable (cv).

2. Determine what the increase in total benefits would be if one more unit of the control variable were added.

This is the marginal benefit of the added unit.

Key Procedure for Using Marginal Analysis

3. Determine what the increase in total cost would be if one more unit of the control variable were added.

This is the marginal cost of the added unit.

Key Procedure for Using Marginal Analysis

4. If the unit's marginal benefit exceeds (or equals) its marginal cost, it should be added.

Key Procedure for Using Marginal Analysis

Remember to look only at the changes in total benefits and total costs.

If a particular cost or benefit does not change, IGNORE IT !

Why Does This Work?Because:

Marginal Benefit = Increase in Total Benefits

per unit of control variable

TR / Qcv = MR

where cv = control variable

Why Does This Work?Marginal Cost = Increase in Total

Costs per unit of control

variable

TC / Qcv = MC

Why Does This Work?So:

Change in Net Benefits = Marginal Benefit - Marginal Cost

Why Does This Work?When marginal benefits exceed

marginal cost, net benefits go up.

So the marginal unit of the control variable should be added.

Example: Should a firm produce more ?

A firm's net benefit of being in business is PROFIT.

The following equation calculates profit:

PROFIT = TOTAL REVENUE - TOTAL COST

Example: Should a firm produce more ?

Where:

TR = (Poutput X Qoutput) n

TC = (Pinputi X Qinputi

) i=1

Assume the firm's control variable is the output it produces.

Maximization occurs when marginal switches from positive to negative.

If marginal is above average, average is rising.

If marginal is below average, average is falling.

Graphing Total, Marginal, and Average Relations Deriving Totals from Marginal and Average

Curves Total is the sum of marginals.

OUTPUT TOTAL MARGINAL AVERAGE PER DAY PROFIT PROFIT PROFIT

0 01 100 100 100.02 250 150 125.03 600 350 200.04 1000 400 250.05 1350 350 270.06 1500 150 250.07 1550 50 221.48 1500 -50 187.59 1400 -100 155.6

10 1200 -200 120.0

Total, marginal, and average profit

-500

0

500

1000

1500

2000

0 5 10 15

OUTPUT PER DAY

PRO

FIT

TOTAL PROFITMARGINALPROFITAVERAGE PROFIT

RationalityoEconomists make the assumption tat

people act rationally. This means that consumers and producers measure and compare the costs and benefits of a decision before going ahead.

oEx: whether eating at home is cheaper than going to a restaurant.

oWhether the owner of a firm also acts as the manager of the firm.

oWhether to train the existing workers or recruit new workers for the newly opened unit of the firm, and so on.

oHowever, it may be more enjoyable to eat at the restaurant; the owner can employ a manager; training existing workers may be costlier than hiring trained workers, and so on.

oThus rationality involves making a choice that gives the greatest benefit relative to cost.

oAll of conventional economic theory rests on the assumption that consumers and producers all behave rationally, while firms aim at maximizing profits and minimizing costs, consumers aim at maximizing utility and minimizing sacrifice.

General Equilibrium & Partial Equilibrium

oPartial equilibrium analysis (PEA) and general equilibrium analysis (GEA) are two different approaches for analyzing the functioning of an economy with inter-related markets.

oPartial Equilibrium AnalysisoPEA was popularized by an English economist, Alfred

Marshall, in the 19th century. PEA studies a market in isolation as it facilitates the detailed analysis of the impact of forces in a particular market, such as the forces of demand and supply as related to changes in price. In PEA, the market under study is isolated from the rest of the economy. In PEA, each product or factor market is considered as independent and self-contained for a proper explanation of the determination of price and quantity of a commodity or a factor. 

Cont:oLimitations of PEA oPEA sets a framework to learn the functioning of

each market in an economy. However, it is not applicable when there is interrelationship between commodities or between factors of production. Further, it is very complex to apply PEA to understand how an economy functions as a whole. In fact, in the actual functioning of an economy, the demand and supply of one commodity influences the prices of other commodities in the market. For instance, when the demand for automobiles goes up, it influences the price of fuel and the raw material for manufacturing automobiles, which includes steel, rubber, glass, etc. But PEA ignores all these interrelationships.

General EquilibriumoAs PEA is not applicable for analysis of markets that are

interdependent, GEA is applied. GEA, which takes into consideration simultaneous equilibrium of all markets, is employed to study the economy as a whole.

oWhen the economic system as a whole is considered, there is a great deal of inter-relationship and interdependence between the various markets for commodities and factors of production, and there are large number of decision-making agents—consumers, producers, workers, and other resource owners. All these agents are assumed to behave in a way that maximizes their satisfaction. GEA focuses on how the different factors function simultaneously in the economy.

oThough GEA is more comprehensive in scope than PEA, both PEA and GEA are useful in their own way. PEA provides an explanation for determining price and quantity for a given product or factor market when each market is independent and viewed in isolation. GEA, on the other hand, explains simultaneous equilibrium of markets when prices and quantities of products and factors are considered as variables.

The Process of Model-buildingoThe economics ‘method’

o‘illicit relationships with beautiful models’oThe steps: the hypothetical-deductive

approachomake assumptions about behaviourowork out the consequences of those

assumptionsomake predictionsotest the predictions against the evidenceoPREDICTIONS SUPPORTED? The model is

accepted as a good explanation (for the moment)

oPREDICTIONS REFUTED? Go back and re-work the whole process

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Definitions&

assumptions

Predictions

If predictionsnot supported by

data, model isamended ordiscarded

If predictions borne out by

data, the model is valid, for the moment

Theoreticalanalysis

Predictionstested

against data

What Is A “Good” Model?

oIt allows us to make predictions and set hypotheses

oThe predictions can be tested against the empirical evidence

oThe predictions are supported by the empirical evidence

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