As we know, life is all about choices, big and small. Individuals and businesses are constantly making choices while weighing their costs and benefits to try to maximize some result. We choose how to spend our time and money; businesses choose products to sell and how to operate; and as a society we make collective choices that impact our lives.

Whether we are trying to figure out what to do on a Saturday night, or a developer is trying to decide about the best housing options for a project, or government officials are trying to set air quality standards, the thinking process in the decision making is the same. There are some simple thought mechanics used in balancing costs and benefits to find a best strategy. And the same processes are used by everyone: individuals, businesses, and society in general. This chapter introduces those mechanics.

In this chapter, we will learn how individuals, businesses, and society use some specific “rules” for maximizing as they go through the mechanics of weighing costs and benefits. You will also be introduced to marginal analysis, which is the basis of many microeconomic concepts. Marginal analysis will reappear in most of the following chapters.

The formal study of the process of balancing costs and benefits, referred to as cost-benefit analysis, is helpful in evaluating business investment and production decisions, government spending decisions, and individual decisions concerning major purchases. However, the principles of cost-benefit analysis are not limited in their usefulness to evaluating major economic and financial decisions. The principles can be applied to many more areas of human experience than those dealt with in modern economics. The story of Adam and Eve, and the choice to eat the apple in the Garden of Eden, is a lesson in balancing costs and benefits, as is an expression such as:

All rational decision making, be it economic or noneconomic, is based on the balancing of costs and benefits in order to, in the view of the decision maker, maximize something. This is true for the worker trying to maximize well-being by balancing the costs and benefits of working overtime, or for the child weighing the costs and benefits of lying to a parent, or for the painter deciding whether to move the ladder or stretch to reach the last few inches on a wall.

BALANCING BENEFITS AND COSTS: THE INDIVIDUAL

Defining Benefits and Costs

When people make decisions, from whether or not to carry an umbrella to class to whether or not to smoke, the goal of this decision making is to maximize, or to get the most from the decision. In doing so, an individual, usually subconsciously, uses a type of mathematical process, or applies certain mathematical rules, to weigh the costs and benefits of different courses of action. (Yes, even when trying to decide what to order at our favorite lunch spot, our brains are engaged in using mathematics to make a decision.) Before we thoroughly discuss this process and these rules, let's understand how an individual measures benefits and costs.

The benefit to a person from any action or purchase is the amount of satisfaction received from that action or purchase. This satisfaction, discussed in Chapter 10, is referred to as utility. In order to understand the behavior of utility, assume people have a small meter in their heads called a “Util-O-Meter.” This meter measures total utility by clicking off points according to the amount of satisfaction received from each additional performance of an action or from the consumption of each additional unit of a good or service.

TABLE 11.1 Ranking Satisfaction

Any measurement of satisfaction is highly subjective, as are the numbers registered on a Util-O-Meter for the benefits received from any action or purchase. Because of this, it is extremely difficult for two people to compare the degree of satisfaction received by each from taking the same action, such as eating a slice of pizza. However, a person can compare the degree of satisfaction that the person receives from different actions or purchases from which that person can choose. You, for example, know whether you enjoy a popular recording more, much more, or not as much as Mahler's Seventh Symphony. Try the exercise in Table 11.1 to reinforce this point.

An individual usually measures the cost of an item by the dollars paid for it. As discussed in Chapter 1, however, cost can also be measured in terms of the alternative or opportunity forgone to acquire an item or take an action. That is, the cost of something can be measured in terms of its opportunity cost. For example, the cost of a $100 textbook could be measured by the dollars required to obtain it or by the football tickets, groceries, shirt, or whatever else would have otherwise been purchased.

Everything one does has an opportunity cost. The cost of attending a class could be sleep, working out, watching a television program, or putting in an extra hour at a job. What is your opportunity cost of reading this chapter now?

We can relate opportunity costs to utility, or satisfaction, by measuring the points that would have been added to a Util-O-Meter had another course of action been chosen. For example, if by registering for next term you gave up 1 hour of running, which would have added 125 points to your total utility, then the opportunity cost of registering was 125 points.

Measuring Benefits and Costs

In the example that follows, we will show how individuals measure the benefits and costs of actions and how they apply some simple mathematical maximizing rules to their decision making. This example deals with a student who is planning to spend an evening at a concert on campus. The concert is lengthy and informal: People can come and go as they please. There is no admission charge, but the concert is not free because someone who attends has an opportunity cost in terms of time.

Remember that people try to maximize their satisfaction in taking actions. In this case, the individual going to the concert is attempting to maximize the satisfaction from the time spent during the course of the evening. This means that our concertgoer may spend the entire evening at the concert or may at some point have something else preferable to do and leave the concert. In this example, we will determine whether satisfaction is maximized by attending the entire concert, which lasts for 5 hours, or by leaving after the first, second, third, or fourth hour.

Measuring Benefits By attending the concert, our student receives satisfaction, or utility: The concert adds points to the individual's Util-O-Meter. Each additional hour spent at the concert adds a certain number of points to total satisfaction. The change in total satisfaction from attending each additional hour is called marginal benefit, or marginal utility. The total satisfaction received by attending the concert for a specified number of hours is called total benefit, or total utility.

Let's assume that our student's Util-O-Meter registers zero before the concert. Let us further assume that by the end of the first hour, 400 points of utility have clicked onto the meter. This means that the total benefit, or utility, from spending 1 hour at the concert is 400 points. At the end of the second hour, 700 points are registered on the meter; or we can say that the total benefit from spending 2 hours at the concert is 700 points. At the end of 3 hours, 900 points are registered; at the end of 4 hours, the total utility received is 1,000 points; and after 5 hours, the meter still registers 1,000 points. This information is given in Table 11.2 in the column labeled Total Benefit (Utility).

Marginal benefit, or utility, is the change in total benefit that results from attending the concert for each additional hour. Because the Util-O-Meter registered zero before the concert and 400 points at the end of 1 hour, the marginal benefit from the first hour is 400 points. At the end of the second hour, 700 points of total benefit are registered, which means that 300 points of utility are added during the second hour (700 points in total utility at the end of the second hour minus 400 points at the end of the first). Thus, the marginal utility, or benefit, of the second hour is 300 points. During the third hour, 200 points of marginal benefit are added (total benefit increases from 700 to 900 points). The marginal benefit of the fourth hour is 100 points; and the marginal benefit of the fifth hour is zero points because total benefit does not increase from the end of the fourth to the end of the fifth hour. These measures are given in Table 11.2 in the column labeled Marginal Benefit (Utility).

You may have noticed that the marginal benefit points given in Table 11.2 are listed midway between the hours. This is done because marginal values refer to changes in total values. When showing a change in total value, or marginal value, in a table like 11.2, the common practice is to place the number for the marginal value between the start point and end point of what is being measured.

Notice that the marginal benefit points decrease with each additional hour spent at the concert. In this example, this individual really enjoys the first hour, finds the second hour slightly less satisfying, and finds each successive hour less enjoyable than the previous one. By the fifth hour no additional satisfaction is received. This result is consistent with a principle in economics called the Law of Diminishing Marginal Utility. This law states that, as additional units of an item are consumed, beyond some point each successive unit consumed adds less to total utility than was added by the unit consumed just before it. In other words, as an individual consumes a good or service, there is some point beyond which he or she enjoys each additional unit of the item less.²

TABLE 11.2 Utility Points from Attending a Concert

Food provides excellent examples of the Law of Diminishing Marginal Utility. If you are eating pizza, tacos, doughnuts, or anything else, there is some point beyond which each additional piece of pizza or taco or doughnut gives you less satisfaction than the one before it. Do you generally enjoy the fourth doughnut as much as the first? Also, would you enjoy a second bike or cell phone as much as the first, and do you find the third hour of a 3-hour lecture class as satisfying and stimulating as the second or first hour? And, sometimes even a concert by a musician or group that we really like gets tiresome after awhile.

Measuring Costs In our concertgoer example, the student faces costs as well as receiving benefits from attending the concert. These costs are opportunity costs based on forgone uses of the student's time, such as studying or watching television, which would have also given the student satisfaction, or would have added points to the student's Util-O-Meter. Thus, the costs of the concert can be measured by the number of forgone utility points from alternative opportunities.

Table 11.3 gives the total and marginal costs, measured in forgone satisfaction points, of spending the evening at the concert. Total cost is the cost of spending a specified number of hours at the concert. Marginal cost is the change in total cost from each additional hour spent at the concert. As before, the marginal measurements are given at the midpoints between the hours.

TABLE 11.3 Total and Marginal Costs of Attending a Concert

Our student has many alternatives to attending the concert. Assume that one alternative to attending the concert for 1 hour is doing laundry. This action would give our concertgoer 25 Util-O-Meter points, thereby making the marginal opportunity cost of the first hour at the concert 25 points. These 25 marginal cost points equal the total cost for attending the concert for 1 hour because no previous total cost points have been accumulated.

To attend the second hour of the concert, assume that the student in our example gives up socializing with a friend that would have yielded 50 additional points of satisfaction, thereby making the marginal cost of the second hour 50 points. When these 50 marginal points are added to the total cost of 25 points for the first hour, the total cost of 2 hours at the concert becomes 75 points. The marginal cost of the third hour is 100 points of satisfaction that our student would have received from working out at the rec center. When these 100 marginal points are added to the 75 total cost points for 2 hours spent at the concert, the total cost of 3 hours at the concert becomes 175 points.

The alternative to the fourth hour at the concert is studying for an economics quiz that must be taken the following morning. The marginal cost of this hour is the 200 points that would be added to total satisfaction by working for a good grade on the quiz. These points, when added to the 175 points for 3 hours, make the total cost of 4 hours at the concert 375 points. The marginal cost of the fifth hour is 625 points, which is the satisfaction that would be received by putting the finishing touches on an application for law school admission that has to go out the following morning. These 625 marginal cost points bring the total cost of attending the entire 5-hour concert to 1,000 points.

Notice that the marginal cost of attending each additional hour of the concert rises with the number of hours attended. The individual first gives up those alternatives that cost the least, and, as the evening goes on, the alternatives become more and more expensive.

TABLE 11.4 Benefits and Costs of Attending a Concert (in Utility Points)

Maximizing Satisfaction

So far we have measured the benefits and costs for a student spending an evening at a concert. Remembering that the goal of any action is to maximize satisfaction, we will now evaluate these benefits and costs to determine the number of hours that the student would spend at the concert to accomplish this objective.

Table 11.4 lists the concertgoer's total and marginal benefits as well as the total and marginal costs that were given in Tables 11.2 and 11.3. Table 11.4 also includes a measure of the net benefit received from spending a specified number of hours at the concert. Net benefit is what the concertgoer is trying to maximize. Table 11.4 indicates that the net benefit of 1 hour at the concert is 375 points, the net benefit of 2 hours is 625 points, and so on.

The net benefit points given in Table 11.4 show that satisfaction from the concert is maximized by attending for 3 hours. At the end of 3 hours, 725 net benefit points, the most that our student can get from this concert, have been realized. Attending the concert for just 1 or 2 hours or staying for 4 or 5 hours will yield less satisfaction than 725 points.

How is net benefit calculated? The net benefit for a specified number of hours at the concert is simply the result when the total cost of those hours is subtracted from the total benefit. For example, as shown in Table 11.4, the total benefit from attending the concert for 1 hour is 400 points and the total cost is 25 points, leaving a net benefit of 375 points; the total benefit from attending for 2 hours is 700 points and the total cost is 75 points, leaving a net benefit of 625 points; and so on.

Net Benefit Maximizing Rules There are two net benefit maximizing rules with each rule providing the same answer.

• Net benefit is maximized where total benefit exceeds total cost by the greatest amount.
• Net benefit is maximized where marginal benefit equals marginal cost.

For our student, net benefit is maximized at 3 hours. It is easy to apply the first rule and see this result. But the second rule, the marginal benefit equals marginal cost rule, is not so easy to see. Let's go back to Table 11.4.

For the first hour of the concert, the marginal benefit is 400 points and the marginal cost is 25 points. If you think of marginal benefit as adding points to a Util-O-Meter and marginal cost as subtracting points, then 400 points are added and 25 are subtracted during the first hour, leaving a gain in satisfaction, or gain in net benefit, of 375 points.

During the second hour, 300 more points, the marginal benefit, are added and 50 points, the marginal cost, are subtracted. The result is a gain in net benefit of 250 points to be added to the gain from the first hour. Thus, the net benefit after 2 hours is 625 points (375 points from the first hour plus 250 points from the second hour). During the third hour, 200 marginal benefit points are added and only 100 marginal cost points are subtracted, increasing the net benefit registered by 100 points and bringing it to 725 on the Util-O-Meter.

Notice that for each of these 3 hours, marginal benefit is greater than marginal cost, causing net benefit to increase. But also notice that marginal benefit is shrinking and marginal cost is growing. At some point they will be equal.

During the fourth hour, the marginal benefit is only 100 points, but the marginal cost is 200 points, causing more to be subtracted from total satisfaction than is added. Because of this, net benefit falls from 725 points to 625 points. If our student stayed at the concert for a fourth hour, that fourth hour would cost more satisfaction than it would give. During the fifth hour no points are added, but 625 are subtracted, causing net benefit again to fall.

We can see that our student is increasing satisfaction, or net benefit, by attending the concert as long as more utility points are added from the concert than would be added from the alternatives. Once the alternatives become more attractive, it is to the individual's advantage to switch from the concert to an alternative.

Clearly, using the marginal cost–marginal benefit approach, net benefit is maximized by attending the concert for 3 hours. During the third hour, more marginal benefit points are added than marginal cost points are subtracted, but during the fourth hour more marginal cost points are subtracted than marginal benefit points are added. The concertgoer should leave at the end of 3 hours because at this point marginal cost equals marginal benefit. This equality will be easy to see when this relationship is graphed in the next section.

From this we can conclude that

• net benefit increases as long as marginal benefit is greater than marginal cost, no matter how small the difference;
• net benefit decreases when marginal cost becomes greater than marginal benefit because more is subtracted than is added to satisfaction; and
• net benefit is maximized at the point where marginal cost equals marginal benefit.

In summary, this example illustrates the two rules for maximizing net benefit, both yielding the same result. These rules are so important that we will restate them one more time. Maximization occurs where total benefit exceeds total cost by the greatest amount or where marginal benefit equals marginal cost.

Would you act as the student in our example did? Most likely you would. Have you ever returned early from a date, movie, or shopping because an important test or job interview was scheduled early the next morning? You have applied the maximizing rules in countless situations where you, perhaps subconsciously, weighed the marginal cost and marginal benefit of an action. For example, the decision of whether to eat one more chocolate chip cookie involves balancing the additional cost of the extra calories against the additional enjoyment from the cookie. Other decisions, such as which route to take to work on a snowy day, or whether to access online student tutorials that accompany a textbook, or whether to purchase an expensive or cheap pair of boots, all involve an application of the maximizing rules. What are some of the marginal costs and marginal benefits that might be considered in deciding whether to break the speed limit to arrive at work on time? Application 11.1, “Do It Yourself,” gives some additional examples of the application of cost-benefit principles. Do you recognize yourself or someone you know in this application?

APPLICATION 11.1

Graphing Costs, Benefits, and Net Benefit

The relationships that were just introduced can be illustrated graphically. Our student's total cost and total benefit from attending the concert are shown in the upper graph of Figure 11.1, marginal cost and marginal benefit are given in the middle graph, and net benefit is shown in the lower graph. These figures are plotted from the information in Table 11.4.

As long as total benefit is greater than total cost, there is a positive net benefit. As can be seen in the upper graph of Figure 11.1, net benefit is equal to the vertical distance between total benefit and total cost for any given number of hours spent attending the concert. Thus, maximum net benefit occurs where the vertical distance between total benefit and total cost is the greatest in the upper graph or at the highest point on the net benefit curve in the lower graph. This occurs at 3 hours.

FIGURE 11.1 Total Cost and Benefit, Marginal Cost and Benefit, and Net Benefit

Notice also that as long as marginal benefit is greater than marginal cost in the middle graph, net benefit increases in the lower graph, and when marginal cost is greater than marginal benefit, net benefit falls. Net benefit reaches its maximum where marginal cost equals marginal benefit. This again occurs at 3 hours. You might also notice that marginal cost and marginal benefit are plotted at the midpoints, just as they were given at the midpoints in the tables.

BALANCING BENEFITS AND COSTS: THE BUSINESS

Defining Benefits and Costs

Just like individuals, businesses are constantly making decisions. These range from deciding among candidates to fill a part-time job to advertising budgets to possible mergers. While it may appear that business decision making is quite different from individual decision making, it is actually similar in several respects. Like individuals, businesses try to maximize their economic well-being. And, just like individuals, maximizing by a business requires balancing the costs and benefits of different courses of action to find the one most in its interest.

But a business differs from an individual in that its economic well-being is generally measured in terms of profit rather than utility, or satisfaction. So the goal of a business is to weigh its benefits, which are measured by the revenue it receives from selling a product, against its costs of producing the product to find the output level that maximizes its profit.

In economics, we categorize the various costs of producing a firm's good or service into two groups: explicit and implicit costs. Explicit costs are direct payments, or actual dollar outlays, made by a business for a workforce, materials, machinery, equipment, and so forth. The monthly paychecks that a company issues to its employees, liability insurance payments, and checks to the local paper for an ad are all examples of explicit costs. Explicit costs are sometimes called accounting costs.

Implicit costs are not direct payments for inputs but are opportunity costs to the owner(s) of a business that must be recovered through profit in order for the business to continue. Implicit costs could be forgone interest from money the owners have invested in the business rather than in securities, rental payments that could have been earned if a building that houses the business were leased to another company, income the owners could have received by using their talents and efforts in an alternative enterprise, or any other returns that have been given up by the owners.

The profit that the owners of a business expect to earn to cover their implicit costs is called normal profit. Normal profit is necessary to keep a business in operation because its owners will use their time, money, or talents in an alternative if they cannot receive the gain necessary to compensate for these inputs. In simple terms, normal profit is the profit necessary to keep a business going.

Because a business will shut down if its owners do not earn a normal profit, normal profit is considered to be an economic cost of production. The economic cost of production of a good or service is equal to the producer's explicit costs plus its implicit costs, or normal profit to its owners.

TABLE 11.5 Revenues from Selling Chairs

Any profit beyond normal profit is called excess profit, or economic profit. For example, if an owner needed $80,000 of normal profit to remain in business and the actual profit were $92,000, then $12,000 would be economic, or excess, profit. Economic, or excess, profit is not a cost, because the owner would remain with the business if it were not earned. Review Question 5 at the end of this chapter provides a good opportunity for you to test your understanding of normal and economic profits.

Application 11.2, “You Need an Economist,” provides some additional thoughts about the value of understanding the need to cover implicit costs in operating a business. Do you know anyone who has not succeeded in business because of the inability to cover implicit costs and earn a normal profit?

Measuring Revenues and Costs

The mechanics for determining profit maximization are the same as those for maximizing satisfaction. The only difference is what is being balanced and what is being maximized. For a business, revenues and costs from operations are being balanced to maximize profit. So the example we are about to work through introduces no new principles. Rather, it shows how the principles already learned for an individual can be applied to a business.

Measuring Revenues Arts and crafts shows are abundant in communities across the country. Suppose that a metal craftsman who produces all sorts of outdoor work—from yard art to iron gates—has also designed a unique rocking chair. This chair appeals to people looking for a piece of useful art for a porch or patio. The craftsman's problem is to determine how many chairs to produce and haul for sale at each fair. He wants to put just the right number of rockers in his truck for any given fair to maximize his profit.

The solution to how many chairs to haul off to a fair is found by balancing the costs from producing different quantities of the chair against the benefits, which in this example are the revenues, from different levels of sales. The revenues that the craftsperson could earn from selling different quantities of the chair at different prices are shown in Table 11.5.

APPLICATION 11.2

The first two columns of the table give the demand for this chair by showing quantities of the chair demanded at different prices. At a price of $450, no chairs would be demanded. But if the price were lowered to $400, one chair would be demanded; if it were $350, two chairs would be demanded; and so on. Thus, the first two columns of Table 11.5 show how the Law of Demand operates for potential chair buyers.

The Total Revenue column in Table 11.5 shows how much revenue would be generated at each level of demand. Total revenue is calculated by multiplying the price of an item by the quantity demanded at that price. For example, two chairs demanded at $350 each would generate $700 in total revenue.

The change in total revenue when one more (or additional) unit of output is demanded is termed marginal revenue. In Table 11.5, the Marginal Revenue column gives the change in total revenue with each additional chair demanded. For example, when the number of chairs demanded goes from zero to one, total revenue changes from $0 to $400, making the marginal revenue from the first chair equal to $400; when the number of chairs demanded goes from one to two, total revenue increases from $400 to $700, making the marginal revenue from the second chair $300; and so on. As was done with marginal benefits and marginal costs in the previous example, the marginal revenues in Table 11.5 are listed at the midpoints between the quantities demanded. (If you are interested in understanding why marginal revenue is less than price for the second, third, and fourth chairs sold, see footnote 3.)³

TABLE 11.6 Costs of Producing Chairs

Measuring Costs The craftsperson's costs are shown in Table 11.6. To keep matters simple, let us say that these costs, which include implicit costs, or normal profit, come to $250 for each rocking chair.

Table 11.6 shows the craftsperson's total cost, which is the cost per chair times the quantity of chairs produced, at various levels of output. At a cost of $250 per chair, total cost would be zero if none were produced, $250 if one chair were produced, $500 ($250 × 2) if two were produced, and so on.

Marginal cost measures how much total cost changes as each additional unit of an item is produced. The Marginal Cost column of Table 11.6 shows the additional cost of producing one more chair. For example, when the quantity goes from zero to one, total cost goes from $0 to $250, making the marginal cost of the first chair equal to $250. When the quantity changes from one to two, total cost goes from $250 to $500, and the marginal cost of the second chair is again $250. As was done with the previous marginal values, the marginal costs in Table 11.6 are listed between the quantities produced.

Maximizing Profit

The number of chairs that the craftsperson should produce and sell to maximize profit can be shown by combining the information from Tables 11.5 and 11.6, as is done in Table 11.7. But before analyzing the numbers in the table, let us review what we should expect to find.

Remember that both the individual at the concert and the craftsperson are trying to maximize net benefit by weighing costs and benefits, and that the only difference between them is how benefits and costs are measured and what they are looking to maximize. Given these similarities, we should expect that the rules for maximizing are the same. So, for the craftsperson, profit should be at a maximum where total revenue exceeds total cost by the greatest amount, or where marginal revenue equals marginal cost. Table 11.7 lets us check this out.

The Profit column in Table 11.7 shows that a maximum profit of $200 occurs at two units of output. How does this relate to total revenue and total cost? Profit or loss is found by subtracting total cost from total revenue at each level of output. For example, if the seller were to produce and sell three chairs, total revenue minus total cost would be $900 − $750, or $150. As indicated in this table, maximum profit for a business occurs where total revenue exceeds total cost by the greatest amount.

What is the relationship between marginal revenue and marginal cost where profit is maximized? Reading down the last two columns in Table 11.7, we can see that from zero to one, and from one to two units of output, marginal revenue is greater than marginal cost: Each chair adds more to total revenue than to total cost, causing profit to increase. This can be verified by noticing that the numbers in the Profit column increase as output and sales go from zero to two units.

In Table 11.7 marginal cost is greater than marginal revenue as output goes from two to three, from three to four, and from four to five units. In this case, the third, fourth, and fifth units are adding more to total cost than to total revenue, causing profit to fall. This is confirmed by the figures in the Profit column.

TABLE 11.7 Revenues, Costs, and Profit on Chairs

Because marginal revenue is greater than marginal cost up to two units of output, and less than marginal cost beyond two units of output, marginal revenue and marginal cost must be equal at two units. Thus, the two profit-maximizing rules are satisfied at an output level of two units. Again, these rules state that profit is maximized at the output level where

• total revenue exceeds total cost by the greatest amount, and
• marginal revenue equals marginal cost.

Graphing Costs, Revenues, and Profit

The relationships among marginal revenue, marginal cost, and profit as well as among total revenue, total cost, and profit that were set out in Table 11.7 are illustrated in Figure 11.2. The bottom graph in Figure 11.2 shows that profit, or net benefit, is at its maximum where two chairs are produced and sold.

The middle graph in Figure 11.2 shows that marginal revenue and marginal cost are equal at exactly two units of output. For smaller output levels, marginal revenue is greater than marginal cost, which causes profit in the lower graph to increase. For output levels larger than two units, marginal revenue is less than marginal cost, causing profit to fall.

Finally, in the upper graph in Figure 11.2, the vertical distance by which the total revenue curve exceeds the total cost curve is at its maximum at two units of output, which, of course, is the output level where profit is maximized in the lower graph.

In summary, regardless of whether an individual, business, or government unit is being considered, the net benefit to the decision-making unit from an activity will be maximized if it operates where total benefit exceeds total cost by the greatest amount. This is also where marginal benefit and marginal cost are equal. The main difference between the decision-making units is not that they follow different rules. Rather, the difference is in what is maximized and how costs and benefits are measured. Working through Test Your Understanding, “Maximizing Profit,” will allow you to master the maximizing rules.

SOCIAL BENEFITS AND COSTS

In the cases just discussed, any concern over whether, how, or to what extent others might be affected by an individual's or a business's decision was absent. People generally choose courses of action after considering the factors that affect them directly, even though sometimes what they do will benefit or impose a cost on others. Because of this, the costs and benefits to individuals and businesses of their actions may differ from the costs and benefits to society of those same actions.

The effects that decisions and actions have on persons or things that are not involved in the decisions or actions are called externalities. Externalities may be either positive and benefit others, or negative and costly to others. For example, getting a flu shot may benefit not only you but also those who could have caught the flu from you. Maintaining your car benefits you and also all the people who could have been delayed if you broke down on the road. In these cases your actions have worked to the advantage of others and have created positive externalities.

FIGURE 11.2 Total Revenue and Cost, Marginal Revenue and Cost, and Profit

TEST YOUR UNDERSTANDING

On the other hand, a factory that pollutes the air or water or individuals who buy alcohol and then drive while intoxicated contribute to the detriment of others and create negative externalities. Because of pollution, residents of a community could incur health problems and additional medical bills or have their property values decrease. For example, in one small town in southeastern Missouri, the dust particles from a lead smelter created some health issues for the community's children and left some homes virtually impossible to sell.

Application 11.3, “The Cost of Smoking,” deals with recent reports by the Centers for Disease Control and Prevention and others on the costs of smoking, many of which are externalities.

Maximizing Society's Net Benefit

Externalities must be added to individual or business cost-benefit calculations to determine how society is affected by an action. The total effect on society of the private benefits and costs plus the externalities of an action are the action's social benefits and social costs. So,

• private benefits + positive externalities = social benefits;
• private costs + negative externalities = social costs; and
• social benefits − social costs = net benefits to society.

APPLICATION 11.3

Net benefit for society is calculated in exactly the same way as that for businesses and individuals. The only difference is that now we are concerned with social rather than private benefits and costs. Thus, the net benefit to society from an activity is maximized where its total social benefit exceeds its total social cost by the greatest amount, or where marginal social benefit equals marginal social cost.

How do externalities affect the relationship between what is best for the individual or business and what is best for society? If an action of an individual or business has no effect on others, there will be no externalities, and the level of activity that maximizes the net benefit of the individual or business will also maximize the net benefit of society. Where private actions impose costs on others and cause negative externalities, the level of activity that maximizes society's net benefit will be less than the level where private net benefit is maximized. For example, if the profit-maximizing output for a business results in costly pollution problems, society would be better off if the firm produced a lower level of output and less pollution. The evidence in Application 11.3 that smoking imposes significant external costs on society strongly suggests that society would be better off with less smoking.

When the actions of an individual or business benefit others and cause positive externalities, the level of activity that maximizes society's net benefit will be greater than the level that maximizes private net benefit. For example, some people maximize private net benefit by not spending money for a college education. But society is clearly better off with an educated population. Cities with a highly educated workforce tend to be more vibrant and economically healthy.

Relationship between Private and Social Net Benefits The relationship between private and social net benefits is shown in Figure 11.3. Figure 11.3a illustrates production with negative but no positive externalities. Here the private marginal costs and benefits from producing this product are represented by PMC and PMB. Private net benefit (in this case, profit) would be maximized where PMB = PMC, which occurs at the output level shown by point Y on the horizontal axis.

Now let's add negative externalities, or costs to society (such as from air pollution), to determine social costs and, from that, the best output level for society. When the negative externalities are added to the private costs, society's marginal cost is represented by SMC in Figure 11.3a. And since there are no positive externalities, society's marginal benefit, SMB, is the same as private marginal benefit (shown by the line PMB = SMB). Now, from society's perspective, the best level of output is shown by point X on the horizontal axis of Figure 11.3a because here society's marginal benefit, SMB, equals society's marginal cost, SMC. In this case, it would be in the interest of society to cut back production from point Y to point X.

Production that yields positive externalities (such as creating jobs in a depressed area) and no negative externalities is shown in Figure 11.3b. In this case, private net benefit would be maximized by producing where private marginal benefit, PMB, and private marginal cost, PMC, are equal, or at point Y on the horizontal axis. But when the positive externalities are added to the private benefit, social marginal benefit, shown by SMB, results. In this case, where no costs are imposed on society (so that PMC = SMC), the best position for society would be at output level Z, where SMB = SMC. Here it would be in society's interest to increase production from point Y to point Z.

FIGURE 11.3 Maximizing Social Net Benefit with Negative and Positive Externalities

In very simple terms, too many goods and services are produced in markets with negative externalities and too few goods and services are produced in markets with positive externalities. If this is the case, how can society induce individuals and businesses to decrease undesirable and increase desirable activities? Activities that produce negative externalities can be reduced through fines, taxes, outright prohibition, or other penalties. Such methods have been used in the United States to control air and water pollution, drunk driving, and crime. To encourage activities that yield positive externalities, government can provide tax breaks, direct grants of money, subsidies, or other inducements. For example, at times local governments have given tax breaks to businesses for locating in their communities, thereby creating new jobs; and the federal government gives various types of financial assistance to students to help them complete their educations.

Up for Debate, “Should Drivers Be Banned from Using Cell Phones While Operating a Vehicle?,” gives two sides of a hotly contested issue. On one side are those who think that the negative externalities created by driving and using a cell phone are so serious that this action should be banned. On the other side are those who think that cell phone usage in cars is part of our lifestyles and that government should not regulate the use. What is your opinion, and how has your assessment of social costs and benefits led you to this position?

PUBLIC CHOICE

The goal of maximizing economic well-being and the principles of cost-benefit analysis are easily understood in the context of individual and business decision making. In our economic system, however, many important decisions are made collectively—that is, by a group. Collective decision making occurs primarily through the government sector. As a group we make choices about how many municipal police cars and dump trucks to purchase, whether to provide more funds for our schools, how much money to allocate to national defense, and whether to permit budget deficits.

UP FOR DEBATE

How do individuals participate in collective decision making? In the United States, voting is the root of collective choice. Individuals elect officials at the federal, state, and local government levels who receive the power and authority to act on behalf of the group. Thus, voting provides the link that transforms individual decision making into collective choice.

The term used to describe the set of economic theories that explains the motives and attitudes of voters and public officials in collective decision making is public choice. The basic idea behind public choice is that people try to maximize their own well-being in making collective choices. Thus, the fundamental rules of decision making do not change when a group is involved.

Maximizing Behavior and the Voting Process

A look at the voting process helps to illustrate public choice theory. For an election, people make some basic decisions: whether to vote or not; how much information to seek about candidates and issues; and for whom to vote. Each of these choices carries costs and benefits.

The act of voting gives individuals varying degrees of satisfaction: If people believe that their votes make a difference, voting gives them more satisfaction than if they feel that their votes have no effect on the outcome of an election. Voting also imposes costs on individuals, especially the opportunity cost of time. Thus, a person's decision about whether or not to vote in an election depends on his or her marginal benefit and marginal cost of voting. If marginal benefit is greater than marginal cost, the person will vote in an election; if marginal cost is greater than marginal benefit, he or she will not vote.

A second consideration in voting involves the amount of information about candidates and issues that a voter has when making a decision at the polls. Generally, when individuals make private decisions about spending large sums of money, they attempt to gather as much information as possible. Do you, for example, know someone who is about to buy a car? That person is probably visiting websites that rate automobiles, taking test drives, and asking current car owners about how much they like a particular model. Many people will pay as much in taxes this year as they do in car payments or even as much as the cost of a new car. Are those people investing as much time and energy in gathering information about the elected officials to whom they are entrusting these tax dollars? Probably not.

Information seeking about candidates and issues takes time. As a result, the opportunity cost of becoming an informed voter can be high, causing a person to be rationally ignorant. That is, a rational voter may perceive that the marginal benefit from becoming better acquainted with a candidate's record and position is less than the marginal cost of becoming enlightened. Because of this, voters often make choices based on limited information that comes from brief advertisements and “sound bites” designed to sell a candidate.

Which candidate does a voter choose? Again, the principles of cost-benefit analysis apply. A voter will select the candidate perceived to bring the greatest net benefit to the voter. This decision could be based on the candidate's record, the position of the candidate on an issue important to the voter, or any other consideration.

Public choice theory, with its emphasis on self-interest, helps to explain many of the problems that result from collective decision making. For example, special-interest groups often cause the will of a minority to be imposed on the majority. Public choice theory explains that members of special-interest groups actively promote their positions through letters, ads, campaign contributions, and other means because of the benefits they expect to receive. The response to these issues from the rest of the population may be weak because of lack of interest or because the opportunity cost of responding is too high. Elected officials are sometimes sensitive to the pleas of special-interest-group members because of the message that they hear or because the group members' support or opposition can impact an official's reelection.

Summary

1. There are general rules for maximizing economic well-being that can be applied to any decision-making unit: an individual, a business, or society. These rules involve the balancing of costs and benefits from different courses of action in order to select the one that contributes most to economic well-being. The formal study of these rules and the balancing of costs and benefits is called cost-benefit analysis. These rules can be applied to many more areas of human endeavor than those traditionally studied in economics courses.
2. For an individual, the benefits of an activity can be measured in terms of the satisfaction, or utility, received from the action. Costs can be measured by the opportunity forgone in accomplishing that action.
3. For a business, benefits are measured by the total revenue received, which is calculated by multiplying the price of an item times the quantity sold. The economic cost of producing a good or service includes explicit costs, which are direct payments for factors of production, and implicit costs, which are returns required by the owner(s) to keep the business in operation. Normal profit is what the owner(s) must earn to recover implicit costs. Economic profit is not a cost of production; it is that profit in excess of normal profit.
4. Total benefit or revenue and total cost are, respectively, the benefit or revenue received and the cost incurred from producing a particular amount of an activity or output. Marginal benefit or revenue is the change in total benefit or revenue resulting from each additional unit of an activity performed or output sold. Marginal cost is the change in total cost from producing one more unit of activity or output.
5. Maximum net benefit (or profit) occurs where total benefit (revenue) exceeds total cost by the greatest amount, or where marginal benefit (revenue) equals marginal cost. Both rules are satisfied at exactly the same level of activity. When marginal benefit (revenue) exceeds marginal cost, net benefit (profit) rises, and when marginal benefit (revenue) is less than marginal cost, net benefit (profit) falls. The main difference in how these rules are applied to various decision-making units is in what is maximized and how benefits and costs are measured.
6. Activities by individuals or businesses may help or hurt others. These effects are called positive and negative externalities. Because of externalities, the level of an activity that maximizes an individual's or a business's net benefit may differ from the level that would maximize society's net benefit.
7. Net benefit is calculated for society in the same way as for individuals and businesses. Society measures its net benefit in terms of social costs and social benefits. Social costs are private costs plus any negative external effects. Social benefits are private benefits plus any positive external effects. When negative externalities are present, society's net benefit is maximized at a lower level of activity than is private net benefit; when positive externalities are present, society's net benefit is maximized at a higher level of activity.
8. Public choice deals with the economic theories behind collective decision making, much of which is carried out through the voting process. Individuals participate in the voting process based on the costs and benefits from the acts of voting, information seeking, and candidate selection. Problems that arise from collective decision making, such as the impact of special-interest groups, can be explained using cost-benefit analysis.

Key Terms and Concepts

Cost-benefit analysis

Utility

Opportunity cost

Marginal benefit (marginal utility)

Total benefit (total utility)

Law of Diminishing Marginal Utility

Total cost

Marginal cost

Net benefit

Net benefit maximizing rules

Explicit costs

Implicit costs

Normal profit

Economic cost of production

Excess profit (economic profit)

Total revenue

Marginal revenue

Profit or loss

Profit-maximizing rules

Externality

Positive externality

Negative externality

Social benefits and costs

Public choice

Rational ignorance

Special-interest group

Review Questions

1. In this chapter, you have been introduced to marginal benefit, marginal utility, marginal revenue, social marginal benefit, marginal cost, and social marginal cost. To what specifically does each term refer and what concept is common to all of these terms?
2. Explain why: (a) net benefit increases when marginal benefit exceeds marginal cost; (b) net benefit is at a maximum when marginal benefit equals marginal cost; and (c) net benefit falls when marginal benefit is less than marginal cost.
3. In what respects are the following maximizing decisions similar to each other and in what respects are they different?
   1. The decision by a person about how much cake to eat
   2. The decision by a community about how many resources to devote to law enforcement
   3. The decision by a business about how much of its product to produce and sell
   4. The decision by a person about how many hours to work per week
4. The following table gives the utility points received by a person from each additional hour of exercise per week, as well as the points that each additional hour costs. Using this table, answer the questions below.

   

   1. Calculate the total benefit and the total cost of exercising for each of the hours in the table.
   2. Calculate the net benefit of exercising for each of the hours in the table.
   3. How many hours per week should this person exercise to maximize satisfaction? What is the maximum number of net benefit points that can be earned from exercising?
   4. Graph total benefit and total cost, marginal benefit and marginal cost, and net benefit on the graphs below. (Remember to plot marginal benefit and marginal cost at the midpoints between the hours.) Explain how these graphs illustrate the maximizing rules.

      

5. Suppose that your neighbor has just closed her books from her first year in the retail flower business and is ecstatic with the profit her accountant says that she has earned. The store grossed $250,000 in sales over the year, and its explicit costs for rent, plants and flowers, electricity, and the like were $175,000. Her husband is not quite as elated but can't figure out exactly why. In discussing the situation with you, he offers the following information. The two of them invested $200,000 of their savings, which was earning an 8 percent return, to go into this business. She gave up her job, which was paying her $64,000 a year, at a local corporation. He worked every evening and most weekends at the store—giving up the opportunity to take on additional clients or to work overtime. In addition to being tired, he figures that he lost $25,000 in additional income. What was their economic cost of production? How much normal profit should they have expected to receive? Have they made any economic profit? What kind of advice would you give them?
6. Using the following cost and revenue information, answer the questions below the table.

   

   1. What are the marginal revenue and marginal cost of each additional unit of output?
   2. What is the profit-maximizing level of output?
   3. What is total profit at the profit-maximizing level of output?
7. Use public choice theory to explain the following.
   1. Low voter turnout for the election of a few candidates for minor offices
   2. Voting along party lines instead of judging each candidate's individual merits
   3. A change before an election in a candidate's position on an issue
   4. Voting according to the recommendations given in a local newspaper
   5. Low voter turnout when the weather is bad

Discussion Questions

1. In each of the following situations, determine what the decision maker might be seeking to maximize and indicate (1) some factors that should be included in the calculation of costs, and (2) some factors that should be included in the calculation of benefits.
   1. The decision to get a college education
   2. The decision to shoplift a coat
   3. The decision by voters to increase property taxes
   4. The decision by a business to drop a product line
   5. The decision to adopt a child
   6. The decision to lie
   7. The decision to stop smoking cigarettes
   8. The decision to text while driving
2. What could be opportunity costs of each of the following actions?
   1. Moving from a smaller home that takes 40 percent of your income to own and maintain to a larger “home of your dreams” that takes 60 percent of your income
   2. Working overtime during the next 2 months in the hope of getting a promotion
   3. Deciding to stop seeing someone because you are not right for each other
   4. Cutting back on certain foods to lose weight
3. Some cities have extensive codes regulating property use, from the type and size of fences and signs that are permitted to maintenance standards that require grass to be cut and yards to be free of derelict vehicles. Is this type of regulation justifiable to prohibit negative externalities that affect the property values of neighbors?
4. The emission of toxins into the air is a well-known example of a negative externality. What are some of the costs imposed on society by these emissions? In answering this question, be sure to consider possible effects from pollution on climate, health, maintenance of buildings and other property, and taxes.
5. Because pesticides and herbicides used by farmers are increasingly poisoning groundwater and streams, would you back a proposal to ban their use? Why?
6. Cost-benefit analysis can be applied to a wide range of economic and noneconomic decisions. Give five examples of noneconomic situations where the cost-benefit analysis developed in this chapter would be useful in arriving at a decision.
7. Although DDT, a pesticide, has been banned in the United States, it is used extensively in many other nations, primarily to curb malaria caused by mosquito bites. In some parts of the world, malaria is a serious health threat. Despite the problems created by extensive use of DDT, many countries find this the least expensive method for attacking malaria and mosquitoes. Using cost-benefit analysis, explain why you would favor or disapprove of the continued use of DDT in some countries.

Critical Thinking Case 11

¹ Alfred Lord Tennyson, “In Memoriam,” in The Poetic and Dramatic Works of Alfred Lord Tennyson, W. J. Rolfe, ed. (Boston: Houghton Mifflin Co., 1898), p. 170.

² We are not suggesting that the second unit consumed of an item will always add less satisfaction than the first or that the third unit will always add less satisfaction than the second. Rather, as successive units of an item are consumed, eventually a point will be reached where each additional unit consumed will add less to total satisfaction than was added by the previous unit. This point may arrive early on, as in the case of our concertgoer, or after the consumption of a large amount of an item.

³ You might have noticed that when the quantity demanded is two, three, or four chairs, marginal revenue is less than the price of the chair. For example, when two chairs are demanded at a price of $350, only $300 is added to total revenue by selling the second chair. Why is this so?

If the craftsperson sells only one chair, $400 in revenue is generated. However, in order to sell two chairs, the price must be lowered to $350. This means that the seller is going to charge $350 to the first buyer as well as the second buyer. Rather than receiving $400 from the first buyer, the craftsperson will have to give the first buyer a $50 discount. Because of this, what is added to total revenue from the sale of the second chair is not its price. Rather, the marginal revenue from the second unit sold is the price of the second unit minus the discount given to the first buyer, or $350 − $50 = $300.

Likewise, if the craftsperson wants to sell three chairs, the price must be lowered to $300. But if the third buyer pays only $300, $300 must also be charged to each of the other two buyers who would have otherwise paid $350. Thus, the marginal revenue from the third unit sold is not equal to the $300 price. Instead, it equals the $300 price minus the two $50 discounts given to the other two buyers, or $300 − $100 = $200. To test your understanding of this principle, see if you can explain why the marginal revenue from the fourth unit is $100, while its price is $250.