We discussed a highly simplified example yesterday. We made our lives easy with a key assumption:
You have already paid for the food in advance and thus there is no opportunity cost.
Let’s change the problem slightly. Suppose now you are in an Ala Carte restaurant, how do you decide how much to order and eat?
This next part is going to be a bit counter-intuitive, so follow me closely.
To solve this problem, we need to answer the following question:
What is the opportunity cost of eating one additional unit of food?
Since the only other option here is to not spend and not eat that one unit, the opportunity cost of eating is the value of not spending. We can approximate that using the price of one unit of food.
Just like there are marginal benefits, there can be marginal costs. In this context, it’s more accurate to call them marginal gross benefit and marginal opportunity cost respectively.
In this situation, the marginal opportunity cost is equals to the price — what you pay to consume an additional unit of the good (or what you do not pay when you don’t spend). It is fixed because the price of food at the restaurant does not vary.
In general, we define marginal cost as the change in total cost when we increase quantity by a little. It exactly parallels the marginal benefit concept. In fact, anything that’s marginal-something in economics will be defined this way.
If we express both benefits and costs as functions of quantity consumed, we can plot them on the same diagram.
Key Concept: Decision making at the margin
We can see from the diagram that any consumer will consume up to the point where marginal benefit (MB) equals to marginal cost (MC).
The intuitive explanation is as follows. If he is rational, he cannot be consuming at MB > MC, because any increase in quantity consumed can lead to further increases in net satisfaction/value.
Similarly, he cannot be consuming at MC > MB, because by cutting down on consumption, he can improve his overall satisfaction.
Thus a rational consumer must be consuming at MB = MC. This process of thinking is called ‘decision making at the margin.’
Math explanation (feel free to skip this section)
Here’s a more mathematical explanation (that’s not required in the A Levels): yesterday we showed that marginal benefit was the derivative of total benefit. We also explained that when MB = 0, total benefit is maximised.
Now, the consumer is trying to maximise his net gain = (total benefit – total opportunity cost). If we differentiate that with respect quantity, we will get (MB – MC). Now, by setting the derivative to zero — i.e. the condition of MB – MC = 0 and thus MB = MC — we can maximise satisfaction.
Don’t worry if you are confused. Most of these concepts are hard to grasp — I had a hard time figuring them out too. We will look at two more examples in the next two days to clear things up.
In summary, rational agents make decisions at the margin. They consider marginal benefits with respect to marginal (opportunity) costs. The optimum point to choose is when MB = MC.
Question of the Day
Explain in your own words why MB = MC is the optimum choice point for economic agents.
The answer to yesterday’s question is You should stop eating when your marginal benefit equals 0, because that is when your total benefit is maximised.
- Why is equating price of each unit of food with marginal opportunity costs considered an approximation? (Think of the definition of opportunity costs)
Explain in your own words, what is the difference, if any, between total costs, marginal costs, and opportunity costs.
We look forward to seeing your responses in the comments section below!
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Till next time, dream economics.
In the age of information, ignorance is a choice.