Unit 1: Introduction to Microeconomics
1.1: What is economics about?
Economics is a very old discipline. As the economist Robert Heilbroner put it, ever since man came down from the trees we have struggled with the problem of survival in the face of finite resources. Ultimately, economics is about the problem of scarcity. We don’t have the resources as a society to produce everything that people might want to consume, so society has to figure out some way to sort this problem out – what to produce, how to gather the resources to produce things, and how to distribute the output we do produce.
A more targeted definition is that economics is the analysis of the production, consumption and distribution of goods and services.
Command Economies and Market Economies
Historically, societies have sorted out this problem and organized their economies in two different ways. For most of human history, people lived in a command economy of some kind, meaning that a central authority allocated resources. Whether it was a tribal chief or a feudal lord, some central authority made a decision about what work needed to be done, who should do it, and what should happen to the product.
By contrast, nowadays most economic decisions are made through free, individual choice. In a
market economy, economic choices are made through individual decision-making. Nobody forces the farmer to grow apples. Nobody tells the store what prices to charge. And nobody tells you how many apples to eat. Yet, somehow all the work manages to get done and you manage to get apples in your refrigerator. It’s pretty amazing, if you think about it. Even though we’re all making our own uncoordinated choices and there’s no lord of the castle to tell us what to do, things come together. Without any central coordination, apples manage to get from farmers to your refrigerator. Modern capitalist economies work pretty well. This is what economics is about.
And the problem of scarcity still isn’t completely sorted out yet – a large segment of the world’s population has a very low standard of living. Nevertheless, it is an undeniable fact that two centuries of capitalism have generated more of an increase in living standards than the tens of thousands of years of human history that preceded capitalism.
Microeconomics and Macroeconomics
There are basically two branches of economics.
• Microeconomics is about individual decisions and individual markets. How should a business set prices in order to maximize its profit? How does competition in the market for cable TV impact consumer prices? How much money should you save for your retirement? These are all microeconomic questions because they are about individual choices and markets for specific goods and services.
• Macroeconomics is about the performance of the economy as a whole. What makes the unemployment rate high? What determines the exchange rate between the US dollar and the Euro? What can the government do to keep prices stable? Why does China grow faster than the US does? These are all macroeconomic questions because they are about the performance of the overall economy, not about specific markets or individual choices.
This is a course in microeconomics. The prefix “micro” is a little bit misleading because microeconomic questions are not necessarily “small” questions. For example, a question about gas taxes and consumption of gasoline affects a lot of people, but it is a microeconomic question because it concerns a particular market. Basically, the performance of the economy as a whole is the subject of macroeconomics. The performance of markets and individual household and business decision-making is the subject of microeconomics.
Positive and Normative Economics
On the other hand, economists sometimes make recommendations about policy or give advice about the way they think the world should operate. For example, economists might give a recommendation about whether it’s a good idea to raise the minimum wage or whether the gasoline tax creates an unfair burden on the poor. These are normative questions. A normative statement is one that involves a value judgment. If I say that the unemployment rate is too high, or that raising the minimum wage is a good idea, then the statement can’t be classified as true or false because it involves my opinions and values.
It is important in economics to distinguish between the two. For example, I might do a research study showing that using the death penalty has no impact on crime rates. This is a positive, scientific statement. My research methodology might be wrong, but the study is not a statement about my opinions. On the other hand, if I then go on to say that the death penalty should be eliminated, I have switched into normative territory. Often, positive findings might have normative implications, but it is important to be clear when doing research and when evaluating the work of others about the difference between the two.
Consensus and Conflict in Economics
Economists can disagree with each other about positive or normative issues. For example, I might write a study showing that raising the minimum wage will not cause any workers to lose their jobs. A colleague might disagree with the way I did my measurements or my research methodology. This is a positive disagreement because it is a disagreement about facts.
On the other hand, I might say that raising the minimum wage is a good idea while a colleague says that raising the minimum wage is a bad idea. This is a normative disagreement because it is a disagreement about our opinions and values.
To close this section, disagreement has always been a signature of economics. Much more so than in other disciplines, disagreement about very core and fundamental issues (both positive and normative) pervade the entire profession. An old joke is that if you get 10 economists in a room you’ll get 11 different answers to any question you ask.
1.2: How economists think
Rationality
The cornerstone of economics is rationality. We believe that people make choices for a reason, acting in their own best interest. The goal is to analyze and understand these choices.
People outside of economics like to criticize this principle, but a lot of this criticism reflects a misunderstanding of what economists mean by rationality. Importantly, rationality allows for a very wide diversity of preferences. Acting rationally doesn’t mean that you have to be selfish or money-hungry. If you enjoy making other people happy, then being charitable is a rational choice for you. All economists are really saying is that, when people make decisions, they make them for a reason. We want to understand why people make the choices they do.
Economists even apply economic reasoning to things like crime and divorce. Why do people commit crimes? Why do people get divorced? Somehow, people must see these choices as being in their best interest at the time, otherwise they wouldn’t make them. As economists, we think we can learn a lot about how the world operates if we try to understand the rational basis behind such decisions. And we can probably make a lot more progress in reducing drug crimes or divorce if we figure out why people make the choices that they do.
So, when we see something that doesn’t appear to make sense, instead of just throwing up our hands and saying that people sometimes make stupid decisions, an economist prefers to delve deeper. I’d rather understand why what we’re observing actually makes sense than to just give up and say that it doesn’t. Indeed, the most interesting questions for economists are about things that don’t seem to make sense. We can often learn a lot by figuring out why they actually do make sense. Economists love puzzles like this. Here are a few examples.
• Ticket prices for rock concerts
Rock concerts usually sell out really fast and have many more interested fans than the number of seats available. Why don’t they raise the price of the tickets? Even if the concert organizers raised their prices, they could still sell all the seats. Are concert organizers really so dumb that they don’t know to set prices? That’s the kind of explanation economists try to avoid. I assume that they know more about selling concert tickets than I do.
mind waiting in line for a long time. The concert organizers prefer to have teenagers come because teenagers buy more merchandise and souvenirs than adults do.
There you go – something that, at first glance, didn’t seem to make sense actually has a perfectly logical explanation. We just had to dig a little bit to figure out what it is. Another explanation is that the long lines provide free advertising for the band.
• Celebrity endorsements
Why does anyone care about celebrity endorsements? A celebrity could just as easily advertise a bad product as advertise a good product. Yet, there is undeniable evidence that celebrity endorsements stimulate sales. Are people just getting tricked into buying things because a celebrity tells them to? That’s the explanation we want to avoid.
There’s actually a good explanation. Say Company A pays a celebrity $1 million to endorse a bad product. Consumers might buy it one time because of the celebrity endorsement, but they’ll never buy it again once they realize the product is bad. Company B pays a celebrity $1 million to endorse a good product. Consumers buy it one time, like the product, keep coming back, and tell their friends. The celebrity endorsement generated one sale per customer for Company A, but generated lots and lots of sales for Company B. In other words, it’s a lot more profitable to pay a celebrity to endorse a high-quality product because consumers will keep coming back and recommending the product to their friends.
So maybe consumers aren’t being stupid when they buy a product because a celebrity endorses it. In reality, these are more likely to be high-quality products.
• Land distribution
Primitive societies used to distribute land to families in scattered parcels in different places. Wouldn’t it cut down on transportation costs to have all your land in one place instead of everyone having land scattered around? Well, it’s actually a form of insurance and risk sharing. If all your land is in one place, then a fire or flood could destroy all your property. But if you own land in different places, then a single disaster won’t destroy all of your property.
• Shopping carts
tricked by this tactic. Second, it assumes that store-owners couldn’t figure this out sooner. If making the cart bigger generates bigger profits for stores, why did they wait so long to do it? Why weren’t the carts always big? There must be something that’s different today.
I don’t know the answer, but there are lots of ideas out there. For one thing, more women work, so they tend to buy more items on each trip since they can’t go to the store as often. Houses are larger than they used to be, so there’s more pantry space. People are richer now than they were 30 years ago, so families can afford to get different food for all family members instead of buying a single meal for everyone. Because of credit cards, people can buy more food on each trip. More single mothers means that there needs to be more room for kids in the cart. More people have cars, which means that parking lots have to be larger, which means that the grocery store has to be further away from the center of the town, which means that people don’t visit as often and need a bigger cart. Also, there has been a technological change – automatic scanners make it a lot less time-consuming to buy many items. All of these are perfectly rational explanations for the evolving size of shopping carts. Economists prefer them because do not require assuming bad decision-making on the part of storeowners and customers.
• Obesity
Why has obesity been rising so much lately? A lot of people blame big portions at restaurants, but that’s a “chicken-or-egg” explanation. Probably, the reason for the big portions is that they’re catering to customers who want to eat more.
Some people say that it’s because we’re richer on average and can afford more food, but that cuts both ways. Richer people can also afford gym memberships and healthier food. Lifestyle differences, like the fact that a lot of people don’t have jobs requiring manual labor, might have something to do with it. But economists have another explanation, which seems odd at first glance – medical advances. Now that we have drugs and treatments that can keep people healthy for longer, it’s not as risky to be obese. So, counterintuitively, things like cholesterol pills may actually be making people more unhealthy. People enjoy their fast food and don’t invest as much in maintaining a healthy weight because they’re counting on the medication being there for them when they get older!
• Voting
To summarize, the core philosophy of economics is rational choice. People make choices for a reason and we’re going to understand the world a lot better if we understand how and why people make the choices that they do.
To close this section with a story, when Einstein observed the movements of Mercury around the sun he noticed some small deviations from Newton’s Laws of Motion. He might have shrugged his shoulders, figured that Newton’s Laws aren’t perfect, and went home for the night. Well, he didn’t. In trying to explain these inconsistencies, he confirmed the general theory of relativity, which is a cornerstone of modern physics. So, when you see something that doesn’t seem to make sense, don’t be so fast to brush it off as irrational behavior. Look a little bit deeper and try to figure out why it might actually make some sense.
Incentives
Because the core dictum of economics is that people act rationally, it stands to reason that their choices will respond to incentives. An incentive is just something that motivates somebody to do something. When you give your little brother candy for keeping his toys out of your room, this is a simple example of an incentive.
For a more serious example, evidence strongly suggests that criminals respond to incentives. A higher chance of getting caught and more severe punishments reduce the number of crimes. Even criminals are acting rationally!
But incentives can sometimes lead to unintended consequences. Here are a few examples.
• Seat belts may have resulted in an increase in traffic fatalities.
It’s definitely true that, if you get into an accident, you’re much less likely to die if you’re wearing a seat belt. So, if the number of traffic accidents were the same, wearing seat belts would cause the number of traffic fatalities to fall.
• The introduction of birth control may have resulted in more sexually transmitted infections.
Along the same lines as the previous example, birth control significantly reduces the costs of having unprotected sex. Responding to incentives, evidence is that people have more unprotected sex as a result, increasing the spread of STI’s.
• A daycare center started charging a fine for late pickups, and the number of late pickups increased.
A daycare center was having a problem with too many parents showing up late to pick up their children, so they started charging a $10 fee for late pickups. The number of late pickups promptly rose. Why? Well, when there is no fee, the “cost” of a late pickup is feeling guilty about making the staff wait around. But when there is a fee, the “cost” of a late pickup is paying $10. Evidently the guilt was more costly than $10. On the other hand, I bet if they raised it to $200 it would be a different story.
• People with less desirable “marriageability” characteristics get married earlier.
There are many things that determine a person’s likely success in the marriage market, both in terms of being able to locate a partner and quality of the partner. Such characteristics include family background, education, physical attractiveness, etc… Yet, people who score worse on these factors tend to get married earlier. Why? Shouldn’t they have more difficulty locating good partners? Well, maybe, but think about incentives. People who know they will have trouble finding partners in the future have more incentive to get married quickly. On the other hand, people who perceive themselves to be the most attractive can afford to pass up early opportunities with the anticipation of finding a better match later.
Models in Economics
Throughout this course, you will see lots of economic models that seem pretty simple – unrealistically simple, and that probably do not capture all the important features of the real world. Many people criticize economists for using unrealistic and overly simplistic models. Is this criticism well-founded?
resistance, drag, temperature differentials, etc… Is this realistic? Of course not; we don’t live in a vacuum. But by eliminating complications, we can narrow our focus to really analyze and understand the essence of gravity. And understanding gravity is a very important piece of understanding the more complex real world. The complications can be added later, but it would be hard to understand how gravity works if you had to immediately incorporate every other force that might influence the final result.
1.3: Fundamentals of economic reasoning
Opportunity Costs
The opportunity cost of any choice that you make is the value of what you give up in order to make that choice. In general, opportunity cost involves two pieces. There are explicit costs, for which money is laid out. Then there are implicit costs, which represent the value of something sacrificed even when no direct payment is made.
The explicit piece is usually pretty straightforward. The explicit cost for you to attend a college class includes the tuition you have to pay, the books you have to buy and the gas that you have to use in order to commute to class. These are sacrifices that you make in order to take the class that you explicitly lay out money for.
The implicit cost of attending a class represents the value of things that you give up in order to take the class, but do not pay for directly. For example, if you have to give up $2000 in wages at your job in order to attend and study for this class, then the foregone wages are an implicit cost associated with attending the class.
The critical point is that opportunity costs include both implicit costs and explicit costs. Suppose you pay $1000 for the tuition to attend a class and you also give up $2000 in wages. To an economist, the true cost for you to attend the class is $3000. This is what you sacrifice by choosing to take the class. Had you not taken the class, you would have been $3000 richer.
In comparing costs and benefits of activities, it is important to have a good sense of how to evaluate opportunity costs properly. Here are a few examples.
• Job training class
A business owner is deciding whether to send his secretary for a training class that costs $5000 and takes two weeks of her time. If she had not attended the class, alternative uses of her time would have been to prepare a report on a new market (value $7000) or upgrade the manager’s computer software (value $3000) or prepare food and coffee (value $1000). None of these tasks can be done without the secretary. What is the opportunity cost of sending the secretary for the training class? If the training class will increase the company’s profit by $10,000, is it worth sending her?
this case, the computer upgrade and the preparation of food and coffee are irrelevant to the problem since the best alternative use of the secretary’s time is to prepare the report. This is what the manager would have had her do if she hadn’t attended the class.
Since the explicit cost is $5000 and the implicit cost is $7000, the opportunity cost of sending the secretary for the class is $12,000. This is what the owner gives up by choosing to send her for the class. Therefore, if the class will increase the profitability of his business by only $10,000, then it’s not worth sending her since this is lower than the opportunity cost associated with her taking the class.
There are two important points to take away from this example. First, opportunity cost represents the value of the best opportunity foregone. Second, failure to consider implicit costs can lead to bad decision-making. In the example above, if the owner had considered only the tuition, he would have sent the secretary for the class. But if he also considers the implicit cost of the secretary’s time, then it isn’t worth sending her.
• Gas stations in Manhattan
You own a piece of land free and clear in the heart of downtown Manhattan. You’re thinking about putting a gas station there. It would cost only $1 million to build and would generate $2 million a year in profits after operating costs. Your accountant says it looks like a winner. Your economist friend is very skeptical. Why?
You have considered only the explicit cost of building and running the gas station. But if you have a piece of property in the heart of Manhattan, you could probably build a skyscraper and make way more than $2 million a year in profits. The implicit cost of using land in downtown Manhattan to build a gas station is huge because alternative uses of the land are so valuable. That’s why there aren’t many gas stations there.
• Lawyers and lawns
You’re the best lawyer in town and you’re also faster at mowing lawns than anyone in town. Should you mow your huge lawn or should you hire someone to do it? Note that the person you hire will not be able to mow the lawn as fast as you could.
• Faculty brats
Cornell University is a very expensive private school. One of the job benefits for professors is free college tuition for your kids. In the old days, professors could send their kids to Cornell at no cost, but had to pay the tuition themselves if they wanted to send their kids to another school. The administrators eventually decided that this policy was unfair and agreed to allow professors to send their kids to Cornell for free or to pay the tuition at any other school. They figured that this change would cost a lot of money. Actually, the school ended up making a profit from this change in policy. What happened?
This is a simple example of failure to consider opportunity costs. Previously, lots of professors were sending their kids to Cornell to benefit from the free tuition. Now, the professors sent their kids elsewhere, which freed up many spaces for tuition-paying students at Cornell. Meanwhile, most of the professors’ kids ended up attending schools that were much cheaper than Cornell. The problem is that the administrators had mistakenly reasoned that it’s free for a professor’s kid to go to Cornell, but it costs money to send the kid to a different school. Of course, the administrators forgot about the implicit cost of faculty children taking up slots of tuition-payers at Cornell. This implicit cost was larger than the explicit cost of sending them somewhere else.
To summarize this discussion, economists emphasize that implicit and explicit costs should be treated the same way for decision-making purposes, and both are included in opportunity costs. Whether I steal $1 out of your wallet (an explicit cost) or whether I prevent you from getting $1 that you would have otherwise received, either way you are out $1. A sacrifice is a sacrifice regardless of whether there is an explicit payment for it or whether you are giving up something that you would have otherwise received.
Sunk Costs
While opportunity costs represent costs that people may fail to take into account when they are making decisions, sunk costs are costs that people mistakenly include in their decision-making process that are actually not relevant.
• Cafeteria food
A student pays $500 at the beginning of the semester pays for a meal plan that allows him to eat as much food as he wants at the cafeteria. Two weeks into the semester, he gets a job at a restaurant that allows him to eat as much free food at the restaurant as he wants. The food at the restaurant is much better than the food at the cafeteria, but he still insists on going to the cafeteria sometimes to get his money’s worth out of the plan he purchased. Does this make sense?
No – The money for the meal plan is lost either way. He might be sorry that he spent it, but at this point the choice is between free food at the cafeteria and free food at the restaurant. The $500 is lost either way, so he might as well eat the food he likes better.
• Movie production
A company has already spent $100 million producing a film that turns out to be awful. At this point, if it chooses to release the movie, the best marketing plan would cost an additional $7 million, and the release would generate $10 million in ticket revenues. The company releases the movie, and a journalist writes an article saying that this was a bad decision – why would you release a movie that costs $107 million to make and market but only generates $10 million in revenues? Is the journalist right?
No – The film company was right to release the movie. Think about it like an accountant first. If the movie is not released, the company loses $100 million. If the movie is released, the company shells out $107 million but earns revenues of $10 million. The company loses $97 million in this case. I’d rather lose $97 million than lose $100 million, so it’s better to release the movie.
Fundamentally, the journalist failed to consider that the $100 million is a sunk cost. That money is lost either way, regardless of whether the film is released, so it is not relevant for making a decision. The only relevant information, moving forward, is that the marketing plan would cost $7 million and generate $10 million in revenues, so it’s worth it. The $100 million sunk cost should not factor into this decision.
• Building a fighter jet
opportunity cost of completing the project? What is the minimum level of benefit that would justify completing the project?
Let’s answer each question in turn. The sunk cost is $45 million – The $40 million labor cost is nonrefundable and also $5 million from the materials cannot be recovered. The opportunity cost of completing the project is $225 million – this includes both the explicit cost of the $170 million in additional materials and also the implicit cost of the $55 million refund that it could have gotten by cancelling the project. Together, the military sacrifices $225 million by completing the project at this point in time. As a result, the project should be completed as long as the benefits from the project are $225 million or more.
Overall, the point is that money already spent and that cannot be recovered should not influence future decision making. You should eat the same amount of food at the buffet regardless of whether you paid $5 to get in or whether you paid $50 to get in. Either way, the money is already gone and, at that point, you can eat as much food as you want for free.
Marginal Analysis
Economists often say that we make decisions at the margin. This is really just a fancy way of saying that, in undertaking any activity, we look at the additional benefits associated with undertaking the activity and compare them to the additional costs associated with undertaking the activity. For example, in deciding how many miles of roadway to build or how large of an airport to build, the government looks at the benefits of additional expansions and compares them with the cost of additional expansions.
Markets Served
Revenues (millions)
Costs (millions)
0 0 0
1 24 4
2 46 10
3 64 18
4 79 32
5 93 50
6 105 74
How many markets should you serve? Your first thought might be to determine your profit associated with each possibility. Profit is your company’s revenue minus the costs it incurs.
Markets Served
Revenues (millions)
Costs (millions)
Profit (millions)
0 0 0 0
1 24 4 20
2 46 10 36
3 64 18 46
4 79 32 47
5 93 50 43
6 105 74 31
The most profitable option is to service 4 markets. This is the right answer, and a perfectly fine way to solve the problem. But there is another approach to this simple problem that illustrates the principle of marginal benefit / marginal cost analysis.
The marginal benefit associated with any one more unit of any activity is the additional benefit that results from that unit. For the example above:
• When the firm services one market, its revenues are $24 million, but when it adds the second market, its revenues increase to $46 million. Thus, the marginal benefit of servicing the second market is $22 million since this is the amount by which revenues rise when the firm adds the second market.
• When the firm services two markets, its revenues are $46 million, but when it adds the third market, its revenues increase to $64 million. Thus, the marginal benefit of servicing the third market is $18 million since this is the amount by which revenues rise when the firm adds the third market.
Continuing with calculations along these lines, the table below shows the marginal benefit (MB) of servicing each additional market.
Markets Served
Revenues
(millions) MB
Costs (millions)
0 0 -- 0
1 24 24 4
2 46 22 10
3 64 18 18
4 79 15 32
5 93 14 50
6 105 12 74
The marginal benefit is the additional benefit or the change in the benefit associated with an additional unit of something. In economics, the term marginal always means “change” or “additional”.
In a similar way, the marginal cost associated with one more unit of any activity is the additional cost that results from that unit. For the example above:
• When the firm services no markets, its costs are $0, but when it services the first market, its costs are $4 million. Thus, the marginal cost of servicing the first market is $4 million since its costs rise by $4 million.
• When the firm services two markets, its costs are $10 million, but when it adds the third market, its costs increase to $18 million. Thus, the marginal cost of servicing the third market is $8 million since this is the amount by which costs rise when the firm adds the third market.
Continuing with the calculation for each unit in the same way, the table below shows the marginal cost (MC) of servicing each additional market.
Markets Served
Revenues
(millions) MB
Costs
(millions) MC
0 0 -- 0 --
1 24 24 4 4
2 46 22 10 6
3 64 18 18 8
4 79 15 32 14
5 93 14 50 18
6 105 12 74 24
Having calculated the marginal benefit and the marginal cost, we are now ready to solve this problem using the marginal approach. Consider each market individually. Remember that the marginal benefit is the additional revenue associated with servicing each market, while the marginal cost is the additional cost associated with servicing each market.
• The first market adds $24 million to our revenues but only adds $4 million to our costs. The first market is worth adding.
• The second market adds $22 million to our revenue and adds $6 million to our costs. The second market is worth adding.
• The third market adds $18 million to our revenue and adds $8 million to our costs. The third market is worth servicing.
• The fourth market adds $15 million to our revenue and adds $14 million to our costs. It’s close, but the fourth market is worth servicing.
• The fifth market adds $14 million to our revenue but adds $18 million to our costs. The fifth market is not worth servicing.
Summarizing, the marginal benefit / marginal cost principle states that any action should be undertaken up to the last unit where the marginal benefit is greater than the marginal cost. Additional action should not be undertaken if the marginal benefit is less than the marginal cost.
In this case, the marginal benefit / marginal cost principle leads us to service 4 markets since this is the last unit where the marginal benefit is greater than the marginal cost. Adding the fifth market would actually reduce our profit since the additional cost of servicing the fifth market exceeds the additional revenues that result. You can confirm by looking back to our calculation of profit. Moving from 4 markets to 5 markets lowers profit from $47 million to $43 million. Basically, we keep going as long as the marginal benefit is greater than the marginal cost, but we stop once the marginal cost exceeds the marginal benefit.
Our final answer – service 4 markets – was the same regardless of whether we used the total profit approach or the marginal approach. Nevertheless, the marginal approach is preferred by economists. Marginal benefit / marginal cost analysis is a very powerful analytical tool, and although this is a simple example, this kind of reasoning will come up over and over again in different contexts throughout the course. It is worth making sure you are comfortable with these simple examples so that you will understand the basic idea when we apply marginal benefit / marginal cost analysis to more complex problems.
A practical example of marginal benefit / marginal cost analysis is vaccination recommendations by the Centers for Disease Control (CDC). When there was an increase in meningitis deaths among college students a few years ago, the CDC considered whether to add the meningitis vaccination to its recommended schedule for all college freshmen. Ultimately, they determined that the number of people who would die from the side effects of the vaccine exceeded the number of deaths from meningitis. In economic language, the CDC decided not to add this additional group to the list of those who are recommended to receive the vaccine because the marginal cost (deaths due to side effects) exceeded the marginal benefit (lives saved by vaccine).
Graphical Approach
How many slices of pizza should you eat? Well, the normal rule is to keep eating as long as the marginal benefit of an additional slice is greater than the marginal cost. You should certainly eat the third slice since the marginal benefit is greater than the marginal cost. But for the fourth slice, the additional benefit is lower than the additional cost, so it’s not worth going on to the fourth slice. But what if you could increase your consumption slightly above 3 pieces – like to 3.1 pieces? It’s worth doing since the marginal benefit is still greater than the marginal cost.
Assuming that you can eat fractional pieces of pizza, the optimal consumption is 3.5 slices. This captures all pizza where marginal benefit exceeds marginal cost, and doesn’t continue on for any pizza where marginal benefit is less than marginal cost. Thus, a simple, elegant rule is:
• Any action should be undertaken up to the point where marginal benefit and marginal cost are equal.
Of course, as we see from the example above, this rule assumes that you can eat fractional pieces of pizza. This might not be practical in all circumstances (try to order 3.5 pieces of pizza from your local Italian eatery!).
