Chapter 3

Optimization:
Doing the
Best You Can

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3 Optimization: Doing the Best You Can

Chapter Outline

3.1 Two Kinds of Optimization: A Matter of Focus

3.2 Optimization in Levels
3.3 Optimization in Differences: Marginal Analysis

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3 Optimization: Doing the Best You Can

Key Ideas
1. When an economic agent chooses the best feasible option, she is
optimizing.
2. Optimization in levels calculates the total net benefit of different
alternatives and then chooses the best alternative.
3. Optimization in differences calculates the change in net benefits
when a person switches from one alternative to another, and then
uses these marginal comparisons to choose the best alternative.
4. Optimization in levels and optimization in differences give
identical answers.
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3 Optimization: Doing the Best You Can

Evidence-Based Economics:
How does location affect the rental cost of housing?

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3.1 A Matter of Focus
Do you always make the best choice? Why not?

Economists believe that optimization describes most of the

choices that economic agents make

Examples:
1) Where to travel in semester break,
2) Which apartment to rent,
3) What price to charge for your goods

Remark: Economists dot assume that people always

successfully optimize

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3.1 A Matter of Focus
Sometimes it is difficult to make choices because

• Limited information
• Sorting through information can be complicated
• Inexperience

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3.1 A Matter of Focus
How to choose? (How to evaluate trade-offs?)
Either
• Optimization in levels =
look at ``total benefit – total cost`` (net benefit)
OR
• Optimization in differences =
look at ``the change in the net benefit of one option compared
to another``

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3.1 A Matter of Focus: Optimization in Levels

Which candy bag does give you more

enjoyment in total?

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3.1 A Matter of Focus: Optimization in Differences
Does this difference increase the value to you?

Remark: In many cases optimization in differences is faster and easier.

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3.2 Optimization in Levels
Decision-making using totals: Where should I live?
Trade-off:
Cost vs. Distance
• Note that to keep
things simple,
we will omit
other factors
• After
understanding
the basics, these
imitted factors
can be included

Exhibit 3.1 Apartments on Your Short List, Which Differ Only on Commuting Time and
Rent and Are Otherwise Identical
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3.2 Optimization in Levels

What does it cost to commute?

• Availability of public transportation

• Gasoline
• Parking
• Wear and tear on car
• Opportunity cost of time

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3.2 Optimization in Levels
• We are focusing on cost in this example
• The benefits of each house is assumed to be same
• If the benefits are the same, optimization become choosing the lowest
cost alternative

Apartment Options

Exhibit 3.1 Apartments on Your Short List, Which Differ Only on Commuting Time and
Rent and Are Otherwise Identical

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3.2 Optimization in Levels

Optimum: the best feasible choice.

In other words, optimum is the optimal choice.

Apartment Options

Exhibit 3.2 Commuting Cost and Rental Cost Expressed in Common Units, Assuming an
Opportunity Cost of Time of $10/hour

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3.2 Optimization in Levels

Exhibit 3.3 Total Cost Including Both Rent and Commuting Cost, Assuming an
Opportunity Cost of Time of $10/hour

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3.2 Optimization in Levels

Comparative Statics: What if the opportunity

cost of commuting changes?

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3.2 Optimization in Levels

Apartment Options

Exhibit 3.4 Commuting Cost and Rental Cost Expressed in Common Units, Assuming an
Opportunity Cost of Time of $15/hour

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3.2 Optimization in Levels

Exhibit 3.6 Total Cost Curves with the Opportunity Cost of Time Equal to $10/hour
and $15/hour

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3.2 Optimization in Levels
What’s Missing?

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3.2 Optimization in Levels

Optimizing in Levels

1. Express all costs and benefits in the same unit (like $)

2. Calculate total net benefit (benefit – costs) for each option
3. Choose the option with the highest net benefit

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3.3 Optimization in Differences: Marginal Analysis
Decision-Making Using Marginal Analysis:
What’s the net benefit of one more?

How many servings do you want?

Marginal analysis is a cost benefit calculation that studies
the difference betwen a feasible alternative and the next
feasible alternative
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3.3 Optimization in Differences: Marginal Analysis
A Comparison of the Apartments:

Exhibit 3.7 Relationship Between Levels and Differences (Margins), Assuming a $10/hour
Opportunity Cost of Time

Marginal cost is the extra cost generated by moving

from one feasible alternative to the next feasible
alternative
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3.3 Optimization in Differences: Marginal Analysis

Principle of Optimization
at the Margin

If an option is the best

choice, you will be made
better off as you move
toward it, and worse off as
you move away from it.

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3.2 Optimization in Differences: Marginal Analysis

Optimizing in Differences:

1. Express all costs and benefits in the same unit

2. Calculate how the costs and benefits change as you
move from one option to another
3. Apply the Principle of Optimization at the Margin—
choose the option that makes you better off by
moving toward it, and worse off by moving away
from it.

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3.2 Optimization in Differences: Marginal Analysis

Exhibit 3.8 Total Cost of Each Apartment and the Marginal Cost of Moving Between
Apartments, Assuming an Opportunity Cost of $10/hour

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3 Optimization: Doing the Best You Can

Evidence-Based Economics:

How does location affect the rental cost of

housing?

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3 Optimization: Doing the Best You Can

Evidence-Based Economics:
How does location affect the rental cost of
housing?

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3 Optimization: Doing the Best You Can

Exhibit 3.9 Apartment Rent in Portland, Oregon, Depends on Distance from the City
Center

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EXERCISES (Questions from the book end of chapter problems):
3. Determine if the following statements better describe optimization in
levels or optimization in differences.

a. John is attempting to decide on a movie. He determines the new

Batman movie provides him with $5 more benefit than the new
Spiderman movie.

b. Marcia finds that the net benefit of flying from Chicago to Honolulu
on a non-stop United Airlines flight is $400, and the net benefit for
the same trip flying on a one-stop American Airlines flight is $200.

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EXERCISES (Questions from the book end of chapter problems):
3. Determine if the following statements better describe optimization in
levels or optimization in differences. (continued)

c. Nikki decided to take the first available parking space as she entered
the student lot. She felt that the first available space had a $5
Premium compared with all other possible spaces because she did
not want to risk being late for her exam.

d. Reagan determined that the net benefit of taking the combination of

two lecture courses and an online lecture course was $100. The same
three courses online gave her a net benefit of $80, and all three in a
lecture-based format gave her a net benefit of $90.

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EXERCISES (Questions from the book end of chapter problems):
5. Your total benefits from consuming different quantities of gas each
week are shown in the following table.
Gallons Per Week Total Benefit (dollar equivalent) Marginal Benefit
0 0 X
1 8
2 15
3 21
4 26
5 30
6 33
7 35
8 36

a. Complete the marginal benefit column starting with the step from 0
gallons to 1 gallon per week.

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EXERCISES (Questions from the book end of chapter problems):
5. Your total benefits from consuming different quantities of gas each
week are shown in the following table.

b. The price of gasoline is $4 per gallon. Use the principle of

Optimization at the Margin to find an optimal number of gallons of
gas to consume each week.

c. Some people have suggested a tax of $2 per gallon of gasoline as a

way to reduce global warming. (Burning fossil fuels such as gasoline
releases greenhouse gasses, which are a cause of global warming.)
Suppose the price of gasoline (including the tax) rises to $6 per
gallon. Use the principle of Optimization at the Margin to find an
optimal number of gallons of gasoline given this new tax on
gasoline.

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EXERCISES (Questions from the book end of chapter problems):
7. Suppose the total benefit and total cost to society of various levels of
pollution reduction are as follows:
(1) (2) (3) (4) (5) (6)
Pollution Total Benefit Total Cost Total Net Marginal Marginal
Reduction Benefit Benefit Cost
0 0 0
1 20 9
2 38 20
3 54 33
4 68 48
5 80 65
6 90 84

a. Complete column (4)

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EXERCISES (Questions from the book end of chapter problems):
7. Suppose the total benefit and total cost to society of various levels of
pollution reduction are as follows:

b. Use optimization in levels to Show that if the U.S. Enviromental

Protection Agency (EPA) wants to maximise total net benefit, then it
should require 3 units of pollution reduction.

c. Complete columns (5) and (6), starting with the step from 0 to 1 unit
of pollution reduction.

d. Show that the Principle of Optimization at the Margin would also tell
the EPA to require 3 units of reduction.

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