Imagine that you have emerged from the forest's edge and are headed for the river. But first you have to walk up and over the hill. If your goal is to walk as far as you can without getting your feet wet, your task is easy. Walk to the river's bank.
But what if instead your goal is to walk to the top of the hill? How would you know when you have reached the top? You could carry an altimeter. Whenever the instrument shows the highest altitude, you're there. Or you could use your eyes. When you are standing on a spot where you cannot see any land above you, you've reached the top.
But what if we accomplish the goal the way that an economist would do it? Analyze one step of your hike at a time. If your first step takes you upward, take the step. If the next step also takes you upward, take that step, too. If the next step takes you downward, stop and back up. Using this method, analyzing one step at a time, will get you to the top of the hill.
If you've read this far, it probably won't surprise you to know that economists have a name for this one-step-at-a-time method. It's called marginal analysis. Remember that in economics we use common, everyday words, but give them special meanings. In this situation, marginal does not mean on the edge or lower quality. In economics, marginal means taking one step at a time. It might mean consuming just one more unit of some good or service. Or expanding your company's production by one more unit. Or hiring one more worker. The word marginal is going to be your new best friend in economics. It will show up over and over.
Recall that economics is fundamentally about choices. And in its simplest form, a choice is a decision between two options. You pick one and do not choose the other. And economists assume that people behave rationally. Each option has a benefit that has a value and a cost that has a value. If the benefit is greater than the cost, a rational person chooses that option. If the benefit is less than the cost, a rational person does not choose that option. This type of rational decision-making is the key to marginal analysis in economics.
For example, you start up a business. You have to answer the question, How big should my business be? By big, you mean, How many units of product should I produce and offer for sale? You want to produce the number of units at which your profit would be maximized. In other words, you are walking up and over the profit hill. How do you know when you are at the top?
You produce one unit of product and you measure its benefit. In this example, the benefit is the revenue you receive for selling the unit. But, in economics, everything comes in two's. So, you must also measure the cost. If the revenue is greater than the cost, then you are climbing up the profit hill. Make that unit of product. Repeat this analysis for each additional unit of product. If the revenue is greater than the cost, take the step and produce the product. But, when you produce a unit of product for which the revenue is less than the cost, that last unit will take you down the profit hill. Stop! Do not make that last unprofitable unit of product. Back up to the unit just before. That's marginal analysis. You analyze one unit of product at a time, comparing the benefit to the cost.
By the way, how do we measure cost? The simple way is to total up the money spent. But economists use a more general definition. When you make a choice between two options, you pick one and do not pick the other option. The option that you pick obviously has a benefit value. But, here's the thing, the option that you do not pick also has a value. You had the opportunity to choose the rejected option, but you sacrificed that opportunity. The value of the option that you did not choose is called opportunity cost. Sometimes opportunity cost is measured in dollars, but it's not necessarily so. Opportunity cost can be measured in whatever way you are measuring benefits. As a rational person, you will choose the option whose benefit is greater than its opportunity cost.
Here's an example. You had to choose whether to read this blog or do something else like doing an Internet search for a friend from high school. It is my fervent hope that, by choosing to read this blog, you are receiving some sort of benefit. But searching for your long-lost friend also provides some sort of benefit. So, you get a benefit from reading the blog, but you also pay an opportunity cost. The opportunity cost is the benefit that you had the opportunity to choose, but you sacrificed. Your opportunity cost is the benefit that you would have received from searching for an old friend. Because I am making the assumption that you are rational, I believe that the benefit of reading this blog today was greater than your opportunity cost. OK, now you can go search for that old flame.
COPYRIGHT © 2009 by Robert D. Sandman
ALL RIGHTS RESERVED.
