1.6 — Marginal Analysis and Consumer Choice

Marginal Analysis is the process of comparing the additional benefits and costs of an action to make decisions that maximize satisfaction (utility) or profit. This is fundamental to decision-making across all economic concepts, and also for the described in 3.6 — Short-Run and Long-Run Decision-Making.

1. Marginal Benefit:
   • The additional satisfaction or utility gained from consuming one more unit of a good or service.
   • Example: The joy from eating a second slice of pizza.
2. Marginal Cost (MC):
   • The additional cost incurred from consuming or producing one more unit of a good or service.
   • Example: The price of the second slice of pizza.
3. Optimal Decision Rule:
   • Rational individuals and firms act where: $\text{MB}=\text{MC}$
   • Decisions continue as long as MB > MC but stop when MB = MC.
4. Law of Diminishing Marginal Utility:
   • As more of a good is consumed, the additional utility gained from each extra unit decreases.
   • Example: The first slice of pizza provides more satisfaction than the fourth.
5. Total vs. Marginal Utility:
   • Total Utility: The overall satisfaction from consuming a set quantity of goods.
   • Marginal Utility: The change in total utility from consuming an additional unit.

Consumer Choice

1. Utility Maximization:
   • Consumers aim to allocate their income to maximize total utility. The utility maximization rule is as follows: $\frac{{\text{MU}}_A}{P_A}=\frac{{\text{MU}}_B}{P_B}$where $\text{MU}$ is marginal utility, and $P$ is the price of goods $A$ and $B$.
2. Budget Constraint:
   • Limited income forces consumers to make trade-offs between goods.
   • Example: Choosing between buying a coffee or a snack.
3. Substitution Effect:
   • When the price of a good rises, consumers buy less of it and more of a cheaper alternative.
   • Example: Switching from steak to chicken when steak prices increase.
4. Income Effect:
   • Changes in a consumer’s purchasing power due to price changes.
   • Example: Lower gas prices leave more money for other goods.

Applications

1. Firms:
   • Decide on production levels based on marginal revenue and marginal cost.
   • Example: A company increases output as long as the marginal revenue (MR) exceeds marginal cost (MC).
2. Consumers:
   • Allocate spending across goods to equalize marginal utility per dollar spent.
   • Example: Spending more on a good with a high marginal utility-to-price ratio.