Lecture 3: Marginal Analysis

for Optimal Decision

McGraw-Hill/I rwin
Copyright 2011 by the McGraw-Hill Companies, I nc. All rights reserved.
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
Choice variables determine the value of
the objective function
Continuous variables
Discrete variables
3-6
Choice Variables
Continuous variables
Can choose from uninterrupted span of
variables
Discrete variables
Must choose from a span of variables that is
interrupted by gaps
3-7
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
3-8
Optimal Level of Activity
(Figure 3.1)
NB
TB
TC
1,000
Level of activity
2,000
4,000
3,000
A
0 1,000 600 200
T
o
t
a
l

b
e
n
e
f
i
t

a
n
d

t
o
t
a
l

c
o
s
t

(
d
o
l
l
a
r
s
)

Panel A Total benefit and total cost curves
A
0 1,000 600 200
Level of activity
N
e
t

b
e
n
e
f
i
t

(
d
o
l
l
a
r
s
)

Panel B Net benefit curve

G
700

F


D
D


C
C


B
B
2,310
1,085
NB* = $1,225

f
350 = A*
350 = A*

M
1,225

c
1,000

d
600
3-9
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
3-10
Marginal Benefit & Marginal Cost
TB
MB
A

Change in total benefit
Change in activity

Change in total benefit

Change in activity
TC
MC
A

3-11
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
3-12
Relating Marginals to Totals
(Figure 3.2)
MC (= slope of TC)
MB (= slope of TB)
TB
TC

F


D
D


C
C
Level of activity
800
1,000
Level of activity
2,000
4,000
3,000
A
0 1,000 600 200
T
o
t
a
l

b
e
n
e
f
i
t

a
n
d

t
o
t
a
l

c
o
s
t

(
d
o
l
l
a
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s
)

Panel A Measuring slopes along TB and TC
A
0 1,000 600 200
M
a
r
g
i
n
a
l

b
e
n
e
f
i
t

a
n
d

m
a
r
g
i
n
a
l

c
o
s
t

(
d
o
l
l
a
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s
)

Panel B Marginals give slopes of totals
800
2
4
6
8
350 = A*
100
520
100
520
350 = A*


B
B
b


G

g
100
320
100
820


d (600, $8.20)
d (600, $3.20)
100
640
100
340


c (200, $3.40)
c (200, $6.40)
5.20
3-13
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
3-14
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
3-15
Using Marginal Analysis to Find A*
(Figure 3.3)
NB
A
0 1,000 600 200
Level of activity
N
e
t

b
e
n
e
f
i
t

(
d
o
l
l
a
r
s
)

800

c

d
100
300
100
500
350 = A*
MB = MC
MB > MC MB < MC

M
3-16
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
3-17
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
3-18
Irrelevance of Sunk, Fixed, and
Average Costs
These costs do not affect marginal cost & are
irrelevant for optimal decisions
3-19
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
3-20
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

...
A B Z
A B Z
MB MB MB
P P P