Opportunity Cost, Marginal

Analysis, Rationalism

Opportunity Cost

oOpportunity

cost
is
the
benefit forgone from the
alternative
that
is
not
selected.
Opportunity cost can be defined as the
cost of any decision measured in terms of
the next best alternative, which has been
sacrificed.

oTo illustrate the concept better, let us assume

that a person who has Rs. 100 at his disposal

can spend it on either of the three options:
a) having a dinner at a restaurant,
b) going for a music concert or
C) for a movie.
The person prefers going for a dinner rather
than to the movie, and the movie over the music
concert. Hence, his opportunity cost is sacrificing
the movie, the next best alternative once he
goes for a dinner.

o
o
o
o

oIf we carry forward the same example at the firm level,

a manager planning to hire a stenographer may have

to give up the idea of having an additional clerk in the
accounts department.
This is applicable even at the national level where the
country allocates higher defense expenditures in the
budget at the cost of using the same money for
infrastructural projects. In order to maximize the value
of the firm, a manager must view costs from this
perspective

Marginalism
oIf resources at disposal of a manager are scarce,
he has to be careful about the utilization of each
and every additional unit of resources. In order
to decide on the use of an additional man-hour
or machine-hour, he needs to know what is the
additional output expected therefrom.
Similarly, a decision about additional investment
has to be taken in view of the additional return
from that investment.
The term marginal is relevant for all such
additional magnitudes of output or return

o
o

Marginal value
The marginal value of a
dependent variable is the
change in this dependent
variable associated with a 1unit change in a particular
independent variable

Marginal Analysis
Marginal analysis is used to
assist people in allocating
their scarce resources to
maximize the benefit of the
output produced.
Simply getting the most
value for the resources used.

Marginal Analysis
Marginal analysis: The analysis of
the benefits and costs of the
marginal unit of a good or input.
(Marginal = the next unit)

Marginal Analysis
A technique widely used in business
decision-making and ties together
much
of economic thought.
In any situation, people want to
maximize net benefits:
Net Benefits = Total Benefits Total Costs

The Control Variable

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

o quantity of a good you buy,

othe quantity of output you produce, or
o the quantity of an input you use.
This variable is called the control
variable .

The Control Variable

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

Key Procedure for Using

Marginal Analysis
1. Identify the control variable (cv).
2.

Determine what the increase in total

benefits would be if one more unit of the
control variable were added.
This is the marginal benefit of the added
unit.

Key Procedure for Using

Marginal Analysis
3.
Determine what the increase
in total cost would be if one
more unit of the control variable
were added.
This is the marginal cost of the
added unit.

Key Procedure for Using

Marginal Analysis
4.
If the unit's marginal benefit
exceeds (or equals) its marginal
cost, it should be added.

Key Procedure for Using

Marginal Analysis
Remember to look only at the
changes in total benefits and
total costs.
If a particular cost or benefit does
not change, IGNORE IT !

Why Does This Work?

Because:
Marginal Benefit = Increase in Total
Benefits
per unit of control
variable
TR / Qcv = MR
where cv = control variable

Why Does This Work?

Marginal Cost = Increase in Total
Costs
per unit of control
variable
TC / Qcv = MC

Why Does This Work?

So:
Change in Net Benefits =
Marginal Benefit Marginal Cost

Why Does This Work?

When marginal benefits exceed
marginal cost, net benefits go
up.
So the marginal unit of the control
variable should be added.

Example: Should a firm

produce more ?
A firm's net benefit of being in business
is PROFIT.
The following equation calculates profit:
PROFIT = TOTAL REVENUE - TOTAL COST

Example: Should a firm

produce more ?
Where:
TR = (Poutput X Qoutput)
n

TC = (Pinputi X Qinputi)
i=1

Assume the firm's control variable is the

output it produces.

Maximization occurs when marginal

switches from positive to negative.
If

marginal is above average,

average is rising.
If marginal is below average,
average is falling.
Graphing Total, Marginal, and
Average Relations

Deriving Totals from Marginal and Average

Curves
Total is the sum of marginals.

OUTPUT
PER DAY
0
1
2
3
4
5
6
7
8
9
10

TOTAL MARGINAL AVERAGE

PROFIT
PROFIT
PROFIT
0
100
100
100.0
250
150
125.0
600
350
200.0
1000
400
250.0
1350
350
270.0
1500
150
250.0
1550
50
221.4
1500
-50
187.5
1400
-100
155.6
1200
-200
120.0

Total, marginal, and average

profit
2000
TOTAL
PROFIT

PROFIT

1500
1000

MARGINAL
PROFIT

500
0
-500 0

10

OUTPUT PER DAY

15

AVERAGE
PROFIT

Rationality

oEconomists make the assumption tat

people act rationally. This means that

consumers and producers measure
and compare the costs and benefits of
a decision before going ahead.
Ex: whether eating at home is
cheaper than going to a restaurant.
Whether the owner of a firm also acts
as the manager of the firm.

o
o

oWhether

to train the existing workers or

recruit new workers for the newly opened
unit of the firm, and so on.
However, it may be more enjoyable to eat
at the restaurant; the owner can employ a
manager; training existing workers may be
costlier than hiring trained workers, and so
on.
Thus rationality involves making a choice
that gives the greatest benefit relative to
cost.
All of conventional economic theory rests on
the assumption that consumers and
producers all behave rationally, while firms
aim at maximizing profits and minimizing
costs, consumers aim at maximizing utility

o
o
o

General Equilibrium & Partial

Equilibrium

oPartial
o
o

equilibrium analysis (PEA) and general

equilibrium analysis (GEA) are two different
approaches for analyzing the functioning of an
economy with inter-related markets.
Partial Equilibrium Analysis
PEA was popularized by an English economist, Alfred
Marshall, in the 19thcentury. PEA studies a market in
isolation as it facilitates the detailed analysis of the
impact of forces in a particular market, such as the
forces of demand and supply as related to changes in
price. In PEA, the market under study is isolated from
the rest of the economy. In PEA, each product or
factor market is considered as independent and selfcontained for a proper explanation of the
determination of price and quantity of a commodity

Cont:

oLimitations of PEA
oPEA sets a framework

to learn the functioning of

each market in an economy. However, it is not
applicable when there is interrelationship between
commodities or between factors of production.
Further, it is very complex to apply PEA to
understand how an economy functions as a whole.
In fact, in the actual functioning of an economy, the
demand and supply of one commodity influences
the prices of other commodities in the market. For
instance, when the demand for automobiles goes
up, it influences the price of fuel and the raw
material for manufacturing automobiles, which
includes steel, rubber, glass, etc. But PEA ignores all
these interrelationships.

General Equilibrium
oAs

PEA is not applicable for analysis of markets that are

interdependent, GEA is applied. GEA, which takes into consideration
simultaneous equilibrium of all markets, is employed to study the
economy as a whole.
When the economic system as a whole is considered, there is a great
deal of inter-relationship and interdependence between the various
markets for commodities and factors of production, and there are
large number of decision-making agentsconsumers, producers,
workers, and other resource owners. All these agents are assumed to
behave in a way that maximizes their satisfaction. GEA focuses on
how the different factors function simultaneously in the economy.
Though GEA is more comprehensive in scope than PEA, both PEA
and GEA are useful in their own way. PEA provides an explanation for
determining price and quantity for a given product or factor market
when each market is independent and viewed in isolation. GEA, on
the other hand, explains simultaneous equilibrium of markets when
prices and quantities of products and factors are considered as
variables.

The Process of Model-building

oThe economics method

oillicit relationships with beautiful models

oThe steps: the hypothetical-deductive

approach

omake assumptions about behaviour

owork out the consequences of those
o
o
o
o

assumptions
make predictions
test the predictions against the evidence
PREDICTIONS SUPPORTED? The model is
accepted as a good explanation (for the
moment)
PREDICTIONS REFUTED? Go back and re-work
the whole process

30

Definitions
&
assumptions
Theoretical
analysis

If predictions
not supported by
data, model is
amended or
discarded

Predictions

Predictions
tested
against data

If predictions
borne out by
data, the model
is valid, for
the moment
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What Is A Good
Model?

oIt allows us to make predictions

and set hypotheses
The predictions can be tested
against the empirical evidence
The predictions are supported
by the empirical evidence

o
o

32

THANK YOU