Decisions are made on the margin. What does that mean? Marginal means an additional unit.
Ultimately, the choices you make should be considered at the margin. Should you eat one more cookie? Study for one more hour?
If you own an auto manufacturing plant, should you produce one more car? This comes down to comparing the marginal benefit of eating that cookie, it's delicious, or studying for that hour, your greater knowledge and higher grades, or selling that car, the revenue you'd get for it, to the marginal cost, the price of the cookie, what you could have done with that hour, like watching TV, or the cost of wages and parts for that car. If the marginal benefit is greater than the marginal cost, then you should do it.
That's the cost-benefit principle. That's rational. As long as the benefit from the next unit is greater than or equal to the cost of that unit, keep doing it.
That's how to make yourself best off. But notice that I didn't say you should eat nothing but cookies, or do nothing but study, or build infinite cars. Most of our choices involve the trade-offs from consuming or producing a little more or a little less.
That's marginal benefit and B, greater than or equal to marginal cost. Why greater than or equal to, not just greater than? Just imagine that it's like a millionth of a penny more benefit than cost. You'd still do it, but it's basically equal.
So now let's take a concrete example. You're in a restaurant looking at the menu. You know where I'm going with this. A taco costs $5 and you're pretty hungry.
So let's write how much buying a certain number of tacos will cost you. So I'm writing out number of tacos, total cost, marginal cost, total benefit, and marginal benefit for the first, second, and third taco. So if they're five dollars each, one taco will cost you five dollars, two tacos cost you ten dollars, three tacos cost you fifteen dollars.
Now let's say that for the first taco you get $8 of benefit since the benefit of zero tacos is $0. Its marginal benefit is $8 and its cost is $5. The benefit of the first taco exceeds the cost, so obviously you should buy it.
Now what if you buy a second one? Your total cost will be $10 because the second taco costs another five bucks. So it's marginal cost. $5.
Now let's say that your benefit from the second taco is $6, your marginal benefit, so you would have $14 of total benefit. Compare the marginal benefit of the second taco to its marginal cost and you'll see that we should still get it because $6 is more than $5. Now let's think about a third taco. The total cost of three tacos is $15. Let's say your total benefit from three tacos is $16.
Well, 16 is more than 15, so you should get the third taco, right? Not so fast. These are Texas-sized tacos, so the third one doesn't really give you much benefit. You're already pretty full. The marginal benefit of the third taco is worth just $2 to you.
16 minus 14. So, buying a third taco costs you... $5 but only makes you $2 better off. That's how we make decisions, by thinking on the margin about buying the next taco rather than all the tacos or none of them. Compare the marginal benefit to the marginal cost, not the total benefit to the total cost.
This approach can help us understand things that seem bizarre without first considering them on the margin. The classic example is the diamond. Water paradox.
Which goes all the way back to Adam Smith writing in 1776 in The Wealth of Nations. He noted that water is essential for life but is incredibly cheap, while diamonds aren't necessary for survival but are expensive. Now lucky for us water is plentiful, so the marginal benefit of one more cup is low, and people won't pay much for it. But diamonds are rare and many people see the marginal benefit of a diamond is high, so they're willing to pay a lot for it. The total benefit of water is much higher than the total benefit of diamonds, but the marginal benefit is what drives the price difference.
When we talk about how prices are determined, these ideas of scarcity and thinking on the margin will be crucial. In fact, comparing marginal benefit and marginal cost is at the core of this class. You're going to get sick of me saying it over and over again as we apply it in pretty much every situation we face. So, make sure you've got it down.
Thinking on the margin, comparing the benefit of the next unit to the cost of the next unit.