Chapter 3

Marginal Analysis for

Optimal Decisions
 Learning Objectives
™ Define several key concepts and terminology related to
marginal analysis
™ Use marginal analysis to find optimal activity levels in
unconstrained maximization problems and explain why
sunk costs, fixed costs, and average costs are irrelevant
for decision making
™ Employ marginal analysis to find the optimal levels of
two or more activities in constrained maximization and
minimization problems

3-2
 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

3-3
 Optimization
™ Maximization problem
~ An optimization problem that involves
maximizing the objective function
™ Minimization problem
~ An optimization problem that involves
minimizing the objective function

3-4
 Optimization
™ Unconstrained 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

3-5
 Choice Variables
™ Activities or choice variables determine
the value of the objective function
™ Discrete choice variables
~ Can only take specific integer values
™ Continuous choice variables
~ Can take any value between two end points

3-6
 Marginal Analysis
™ Analytical techniques for solving
optimization problems that involves
changing values of choice variables by
small amounts to see if the objective
function can be further improved

3-7
2. Unconstrained
maximization

3-8
 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

3-9
 Optimal Level of Activity
(Figure 3.1)
TC
G The level of activity that
4,000 • TB
Total benefit and total cost

maximizes net benefit is

3,000 called the optimal level of
(dollars)

activity.
2,000

1,000

Panel A is the change of

A
0 200 600 1,000
total benefit and total cost
Level of
activity
according to the change of
Panel A – Total benefit and total cost
curves activity.
Panel B is net benefit
Net benefit

associate with TB and TC

(dollars)

curves in panel A
How to find the optimal level
f A
0 200 600
•’ 1,000 of activity?
’
Level of NB
Panel B – Net benefit curve activity 3-10
 Optimal Level of Activity
(Figure 3.1)
TC
G
4,000 • TB
Total benefit and total cost

D
F
• Net benefit at any particular level
• of activity is measured by the
3,000
• D’
(dollars)

2,310 B vertical distance between the

•
2,000 total benefit and total cost curves.
C NB* = $1,225

1,085
•
1,000
• B’ At 350 units in panel A, the
•C vertical distance between TB and
A
’
0 200 350 = A* 600 700 1,000 TC is maximized, and this
Level of
Panel A – Total benefit and total cost activity maximum distance is $1225.
curves
Net benefit
(dollars)

M
1,225
1,000 •c •
600 ’
’ d
•
f A
’
0 200 350 = A* ’ 600 •’ 1,000
’
Level of NB
Panel B – Net benefit curve activity 3-11
Optimal Level of Activity
™ Two important
observations:
9 1. the optimal level of
activity does not generally
result in maximization of
total benefits.
9 2. the optimal level of
activity in an
unconstrained
maximization problem
does not result in
minimization of total cost.
3-12
™ Economists regard marginal analysis as
“the central organizing principle of
economic theory”. Why use marginal
analysis to make optimal decision?
9 The graphical derivation of net benefit only define and
describe the optimal level of activity; it does not explain
why net benefit rises, falls or reaches its peak.
9 Marginal analysis provides a simple and complete
explanation of the underlying forces causing net benefit
to change.
3-13
 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

3-14
Marginal Benefit & Marginal Cost
Marginal benefit and marginal cost can be expressed
mathematically as:

Change in total benefit ΔTB

MB = =
Change in activity ΔA

Change in total benefit ΔTC

MC = =
Change in activity ΔA

3-15
 Relating Marginals to Totals
™ Marginal variables measure rates of
change in corresponding total variables
~ Marginal benefit (marginal cost) of a unit of
activity can be measured by the slope of the
line tangent to the total benefit (total cost)
curve at that point of activity

If you don’t understand, you can read “Brief Review of Derivatives and Optimization” 3-16
 Relating Marginals to Totals
(Figure 3.2)
TC
G
At point C:
4,000 • TB
Total benefit and total cost

100 F
• MB=$6.4, means adding
320
D
•
3,000 100 D• 820 (subtracting) the 200th unit
(dollars)

’
520
100 •B 100
of activity causes total
2,000
640
•C benefit to rise (fall) by $6.4.
1,000
B’
• 520
(we can say: at 200 units
C 100
•
’ 340
of activity, the MB is $6.4
100 A
0 200 350 = A* 600 800 1,000 for the last unit of activity
Level of
Panel A – Measuring slopes along TB and TC activity
undertaken.)
marginal cost (dollars)

MC (= slope of TC)
Marginal benefit and

8 •d’ (600, $8.20) MC=$3.4, means adding

c (200, $6.40)
6 • b (subtracting) the 200th unit
5.20 •
4 d (600, $3.20) of activity causes total
•c’ (200, $3.40) •
2 MB (= slope of TB) cost to rise (fall) by $6.4.
g A
0 200 350 = A* 600 800
•
1,000 So, increasing activities at
Level of
Panel B – Marginals give slopes of totals activity point C can increase TB 3-17
 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

3-18
 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

3-19
Using Marginal Analysis to Find A*
(Figure 3.3)

MB = MC
Net benefit

MB > MC MB < MC
(dollars)

100 M
• 100
300 •c’
’
•
d’
500

’ A
0 200 350 = A* 600 800 1,000
NB
Level of activity

3-20
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

3-21
 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 activity

Decision makers wishing to maximize the

net benefit of an activity should ignore
these costs, why? 3-22
 Irrelevance of Sunk, Fixed, and
Average Costs
™ Decision makers wishing to maximize the
net benefit of an activity should ignore
these costs, because none of these costs
affect the marginal cost of the activity and
so are irrelevant for optimal decisions.

™ Example: P99

3-23
Irrelevance of Sunk, Fixed, and
Average Costs
™ Applied problems:
3 (page 114)

3-24
 3. Constrained
Optimization
™ On many occasions a manager will face situations in which the
choice of activity levels is constrained by the circumstances
surrounding the maximization or minimization problem.

3-25
Marginal benefit per dollar spent on
an activity
™ 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

3-26
Marginal benefit per dollar spent on
an activity
™ Suppose you need a copy machine in the office. You
shop around and find three brands of office copy
machines (brands A, B, and C) that have virtually
identical features.
™ Brand A’s copy machine: costs $2,500, will produce
about 500,000 copies before it wears out.
™ Brand B’s copy machine: costs $4,000, will produce
600,000 copies.
™ Brand C’s copy machine: costs $2,600, will produce
580,000 copies.

How to make decisions?

3-27
 Constrained maximization
™ In the general constrained maximization
problem, a manager must choose the
levels of two or more activities in order to
maximize a total benefit (objective)
function subject to a constraint in the form
of a budget that restricts the amount that
can be spent.

3-28
 Constrained maximization
™ Example (P102-103):
y Consider a situation in which there are two activities, A and B. each
unit of activity A costs $4 to undertake, and each unit of activity B
costs $2 to undertake. The managers faces a constraint that allows
a total expenditure of only $100 on activities A and B combined.
y The manager is currently choosing 20 units of activity A and 10
units of activity B.
y Suppose that the MB of the last unit of activity A is 40 units of
addition benefit and the MB of the last unit of B is 10 units of
addition benefit.

Does this combination maximize revenue?

If not, what should be done? 3-29
 Constrained maximization
™ 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 MBC MBZ

= = ... =
PA PB PC PZ
3-30
 Constrained minimization
™ Constrained minimization problems
involve minimizing a total cost function
(the objective function) subject to a
constraint that the level of activities be
chosen such that a given level of total
benefit is achieved.

3-31
 Constrained minimization
™ Example:
™ Consider a manager who must minimize the total cost of two
activities, A and B, subject to the constraint that 3,000 units of
benefit are to be generated by those activities. The price of activity
A is $5 per unit and the price of activity B is $20 per unit. Suppose
the manager is currently using 100 units of activity A and 60 units
of activity B and this combination of activity generates total benefit
equal to 3,000. At this combination of activities, the marginal
benefit of the last unit of activity A is 30 and the marginal benefit of
the last unit of activity B is 60. Is the cost minimized?

MBA/PA=30/5=6 > MBB/PB=60/20=3

The marginal benefit per dollar spent is greater for activity A than
for activity B. How to reduce cost?
3-32
 MBA/PA=30/5=6 > MBB/PB=60/20=3
™ Reduce activity B by 1 unit:
So, by reducing activity
~ Total benefit fall by 60 units. B by 1 unit and
~ Total cost reduced by $20 increasing activity A by
2 units, the manager
™ Increase activity A by 2 units: reduces total cost by
$10 without reducing
~ Total benefit rise by 60 units.
total benefit.
~ Total cost increase by $10

As long as MBA/PA > MBB/PB, the manager will continue

to increase activity A and decrease activity B at the rate
that holds TB constant until MBA/PA = MBB/PB.
3-33
 Constrained minimization
™ In order to minimize total costs subject to
a constraint on the level of activities,
choose the level of each activity so that
the marginal benefit per dollar spent is
equal for all activities.
MBA MBB MBC MBZ
= = ... =
PA PB PC PZ

3-34
 Summary
™ Marginal analysis is an analytical technique for solving
optimization problems by changing the value of a choice
variable by a small amount to see if the objective
function can be further improved
™ The optimal level of the activity (A*) is that which
maximizes net benefit, and occurs where marginal
benefit equals marginal cost (MB = MC)
~ Sunk costs have previously been paid and cannot be recovered;
Fixed costs are constant and must be paid no matter the level of
activity; Average (or unit) cost is the cost per unit of activity;
these 3 types of costs are irrelevant for optimal decision making
™ The ratio MB/P denotes the additional benefit of that
activity per additional dollar spent (“bang per buck”)
3-35