Managerial Economics

ninth edition

Thomas Maurice

Chapter 3
Marginal Analysis for Optimal Decision Making
McGraw-Hill/Irwin McGraw-Hill/Irwin Managerial Economics, 9e Managerial Economics, 9e
Copyright 2008 by the McGraw-Hill Companies, Inc. All rights reserved.

Managerial Economics

Optimization
An optimization problem involves the specification of three things:
Objective function to be maximized or minimized Activities or choice variables that determine the value of the objective function Any constraints that may restrict the values of the choice variables
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Choice Variables
Choice variables determine the value of the objective function Continuous variables
Can choose from uninterrupted span of variables

Discrete variables
Must choose from a span of variables that is interrupted by gaps
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Net Benefit
Net Benefit (NB)
Difference between total benefit (TB) and total cost (TC) for the activity NB = TB TC

Optimal level of the activity (A*) is the level that maximizes net benefit

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Optimal Level of Activity

(Figure 3.1)
TC G

Total benefit and total cost (dollars)

4,000

3,000 2,310 2,000 C 1,085 1,000 B

D
NB* = $1,225

TB

A 350 = A* 600 700 1,000

200

Level of activity Panel A Total benefit and total cost curves

Net benefit (dollars)

M 1,225 1,000
600

c
200

350 = A*

600

f 1,000 NB

Panel B Net benefit curve

Level of activity

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Marginal Benefit & Marginal Cost

Marginal benefit (MB)
Change in total benefit (TB) caused by an incremental change in the level of the activity

Marginal cost (MC)

Change in total cost (TC) caused by an incremental change in the level of the activity
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Marginal Benefit & Marginal Cost

Change in total benefit TB MB Change in activity A Change in total cost TC MC Change in activity A

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Relating Marginals to Totals

Marginal variables measure rates of change in corresponding total variables
Marginal benefit & marginal cost are also slopes of total benefit & total cost curves, respectively

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Relating Marginals to Totals

(Figure 3.2)
TC G

Total benefit and total cost (dollars)

4,000

100

320
3,000 520 100 2,000 640 1,000 100

B
B

D D
100

820

TB

C
C

520

100

100 340

A 350 = A* 600 800 1,000

200

Level of activity Panel A Measuring slopes along TB and TC

MC (= slope of TC)

Marginal benefit and marginal cost (dollars)

8 6 5.20 4 2

c (200, $6.40)

d (600, $8.20)
d (600, $3.20)

MB (= slope of TB)

c (200, $3.40)
200
350 = A*

600

800

1,000

Panel B Marginals give slopes of totals

Level of activity

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Using Marginal Analysis to Find Optimal Activity Levels

If marginal benefit > marginal cost
Activity should be increased to reach highest net benefit

If marginal cost > marginal benefit

Activity should be decreased to reach highest net benefit

Optimal level of activity

When no further increases in net benefit are possible Occurs when MB = MC
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Using Marginal Analysis to Find A*

(Figure 3.3)

MB = MC

Net benefit (dollars)

MB > MC

MB < MC

100 300

c
200

100

d
350 = A* 600

500

A
0 800 NB 1,000

Level of activity

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Unconstrained Maximization with Discrete Choice Variables

Increase activity if MB > MC Decrease activity if MB < MC Optimal level of activity
Last level for which MB exceeds MC

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Irrelevance of Sunk, Fixed, & Average Costs

Sunk costs
Previously paid & cannot be recovered

Fixed costs
Constant & must be paid no matter the level of activity

Average (or unit) costs

Computed by dividing total cost by the number of units of the activity

These costs do not affect marginal cost & are irrelevant for optimal decisions
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Constrained Optimization
The ratio MB/P represents the additional benefit per additional dollar spent on the activity Ratios of marginal benefits to prices of various activities are used to allocate a fixed number of dollars among activities

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Constrained Optimization
To maximize or minimize an objective function subject to a constraint
Ratios of the marginal benefit to price must be equal for all activities Constraint must be met

MBA MBB MBZ ... PA PB PZ

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