1 Marginal Analysis Comparing Benefits and Costs A Key to Economic Analysis.

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Marginal AnalysisMarginal Analysis

Comparing Benefits and Comparing Benefits and CostsCosts

A Key to Economic A Key to Economic AnalysisAnalysis

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

Simply getting the most value Simply getting the most value for the resources used. for the resources used.

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Marginal analysis: The analysis of Marginal analysis: The analysis of the benefits and costs of the the benefits and costs of the marginal unit of a good or input. marginal unit of a good or input.

Marginal = the next unitMarginal = the next unit

oror

extra, additional, extra, additional, change inchange in

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A technique widely used in business A technique widely used in business decision-making and ties together muchdecision-making and ties together much

of economic thought.of economic thought.

In any situation, people want to maximize In any situation, people want to maximize net benefits:net benefits:

Net Benefits = Total Benefits - Total Net Benefits = Total Benefits - Total CostsCosts

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The Control VariableThe Control Variable

To do marginal analysis, we can change a To do marginal analysis, we can change a variable, such as the:variable, such as the:

quantity of a good you buy, quantity of a good you buy, the quantity of output you produce, orthe quantity of output you produce, or the quantity of an input you use.the quantity of an input you use.

This variable is called theThis variable is called the control variable control variable ..

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The Control VariableThe Control Variable

Marginal analysis focuses upon Marginal analysis focuses upon whether the control variable whether the control variable should be increased by one should be increased by one more unit or notmore unit or not..

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Key Procedure for Using Key Procedure for Using Marginal AnalysisMarginal Analysis

1. Identify the control variable (1. Identify the control variable (cvcv).).

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

This is the This is the marginal benefit marginal benefit of the of the added unit.added unit.

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

This is the This is the marginal cost marginal cost of the of the added unit.added unit.

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

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

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

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Why Does This Work?Why Does This Work?

Because: Because:

Marginal Benefit = Increase in Total Marginal Benefit = Increase in Total BenefitsBenefits

per unit of controlper unit of control

variablevariable

MB = MB = TB / TB / QQcv cv

where cv = control variablewhere cv = control variable

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Marginal Cost = Increase in Marginal Cost = Increase in Total CostsTotal Costs

per unit of per unit of controlcontrol

variablevariable

MC = MC = TC / TC / QQcv cv

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So:So:

Change in Net Benefits = Change in Net Benefits =

Marginal Benefit -Marginal Benefit - Marginal Marginal CostCost

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When marginal benefits exceed When marginal benefits exceed marginal cost, net benefits go marginal cost, net benefits go up.up.

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

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Example: Should a firm Example: Should a firm produce more ?produce more ?

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

The following equation calculates The following equation calculates profit:profit:

PROFIT = TOTAL REVENUE - TOTAL PROFIT = TOTAL REVENUE - TOTAL COSTCOST

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Problem:Problem:

International Widget is producing International Widget is producing fifty widgets at a total cost of fifty widgets at a total cost of $50,000 and is selling them for $50,000 and is selling them for $1,200 each for a total revenue of $1,200 each for a total revenue of $60,000.$60,000.

If it produces a fifty-first widget, its If it produces a fifty-first widget, its total revenue will be $61,200 and total revenue will be $61,200 and its total cost will be $51,500. its total cost will be $51,500.

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Problem:Problem:

Should the firm produce the Should the firm produce the fifty-first widget?fifty-first widget?

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Answer: NOAnswer: NO

The fifty-first widget's marginal The fifty-first widget's marginal benefit is $1,200 benefit is $1,200

($61,200 - $60,000) / 1 ($61,200 - $60,000) / 1

This is the change in total revenue This is the change in total revenue from producing one additional from producing one additional widget and is called marginal widget and is called marginal revenue. revenue.

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Answer:Answer:

The firm's marginal cost is $1,500 The firm's marginal cost is $1,500

($51,500 - $50,000) / 1 ($51,500 - $50,000) / 1

This is the change in total cost from This is the change in total cost from producing one additional widget. producing one additional widget.

This extra widget should This extra widget should NOTNOT be be produced because it does not add produced because it does not add to profit:to profit:

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Answer:Answer:

Change in Net Revenue (Benefit) Change in Net Revenue (Benefit) = =

Marginal Revenue - Marginal Marginal Revenue - Marginal CostCost

- $300 - $300 = $1,200 - $1,500= $1,200 - $1,500

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A Question:A Question:

What is the minimum price What is the minimum price consumers would have to pay consumers would have to pay to get a 51st Widget produced?to get a 51st Widget produced?

Consumers would have to pay Consumers would have to pay at least $1,500 for the extra at least $1,500 for the extra widget to get the producer to widget to get the producer to increase production. increase production.

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SummarySummary

Marginal analysis forms the basis of Marginal analysis forms the basis of economic reasoning. economic reasoning.

To aid in decision-making, marginal To aid in decision-making, marginal analysis looks at the effects of a analysis looks at the effects of a small change in the control variable. small change in the control variable.

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SummarySummary

Each small change produces some Each small change produces some good (its marginal benefit) and good (its marginal benefit) and some bad (its marginal cost). some bad (its marginal cost).

As long as there is more "good" As long as there is more "good" than "bad", the control variable than "bad", the control variable should be increased (since net should be increased (since net benefits will then be increased).benefits will then be increased).

1 Marginal Analysis Comparing Benefits and Costs A Key to Economic Analysis.

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