Chapter 3: Marginal Analysis for Optimal Decision McGraw-Hill/Irwin Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

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

Optimization Maximization problem Minimization problem An optimization problem that involves maximizing the objective function Minimization problem An optimization problem that involves minimizing the objective function

Optimization Unconstrained optimization Constrained optimization An optimization problem in which the decision maker can choose the level of activity from an unrestricted set of values Constrained optimization An optimization problem in which the decision maker chooses values for the choice variables from a restricted set of values

Choice Variables Choice variables determine the value of the objective function Continuous variables Discrete variables

Choice Variables Continuous variables Discrete variables Can choose from uninterrupted span of variables Discrete variables Must choose from a span of variables that is interrupted by gaps

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

Optimal Level of Activity (Figure 3.1) 1,000 Level of activity 2,000 4,000 3,000 A 600 200 Total benefit and total cost (dollars) Panel A – Total benefit and total cost curves TB TC • G 700 • F • D’ D 2,310 1,085 NB* = $1,225 • B B’ • C’ C 350 = A* A 1,000 600 200 Level of activity Net benefit (dollars) Panel B – Net benefit curve • M 1,225 • c’’ 1,000 NB • d’’ 600 • f’’

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

Marginal Benefit & Marginal Cost

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

Relating Marginals to Totals (Figure 3.2) Level of activity 800 1,000 2,000 4,000 3,000 A 600 200 Total benefit and total cost (dollars) Panel A – Measuring slopes along TB and TC Marginal benefit and marginal cost (dollars) Panel B – Marginals give slopes of totals 2 4 6 8 TB TC • G g 100 320 820 • d’ (600, $8.20) d (600, $3.20) • F • D’ D 350 = A* 100 520 • B B’ b 100 640 340 • c’ (200, $3.40) c (200, $6.40) • C’ C MC (= slope of TC) MB (= slope of TB) 5.20

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

Using Marginal Analysis to Find Optimal Activity Levels Optimal level of activity When no further increases in net benefit are possible Occurs when MB = MC

Using Marginal Analysis to Find A* (Figure 3.3) 1,000 600 200 Level of activity Net benefit (dollars) 800 350 = A* MB = MC MB > MC MB < MC 100 300 • M NB • c’’ 100 500 • d’’

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

Irrelevance of Sunk, Fixed, and 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

Irrelevance of Sunk, Fixed, and Average Costs These costs do not affect marginal cost & are irrelevant for optimal decisions

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

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