pcecon.com Class Notes
When a person makes a choice, we call the benefit, happiness, satisfaction, etc. that the person gets from what they choose to do the utility of that choice. For a particular choice, that might be called the marginal utility, if we wish to be specific about the change in happiness or satisfaction that the particular choice or action is giving the person.
We might be tempted to think that choices are just too complicated to get a handle on. However, since many of the alternative options that a person has to select from are unlikely to be selected by that person, we focus only on the two most important options. One of these is the option that the person actually selects and the action that is actually taken. The choice of this option will entail giving up all of the other alternatives available at the time, but only one of these, the second-best alternative, is really important. We call this second-best alternative the opportunity cost of what the person does. It is the highest valued thing given up when the person does what he or she does.
As the scope of a person's choices changes, and as the amount of choice a person has is reduced by their past decisions, we think of this change as a movement from the long run to the short run. What is the difference between the long run and the short run with regard to decision making?
In the long run, a person can do or change (practically) anything.
In the short run, a person is stuck (at least with regard to some things), and some options are cut off.
One way to focus exclusively on those things that a person has control over when he or she makes a particular decision is to specify the margin, or what is marginal. This incremental, additional, or changeable aspect of the person's current situation is all that matters, since it is all that can be affected immediately by his or her choice and action.
Putting the marginal concept together with the opportunity cost concept gives us a pretty good idea of what a person is actually giving up when they make a choice. We call it the marginal opportunity cost, and it is always what we mean when we say "cost" in economics. It is the best alternative action (or thing) that a person could have done or obtained, in a particular situation, but chose not to.
For example, the marginal opportunity cost to a student of attending a one hour class would be the thing that she most would have wanted to do with an hour instead.
A person will choose to do some activity or obtain some good if the marginal utility of doing so is greater than the marginal opportunity cost of doing so.
On the other hand, if the marginal utility of obtaining some good or doing some activity would be less than the marginal opportunity cost, then the person will not do it.
If a person is repeating some action that gives him more utility than he is giving up to do it, he will stop when the marginal utility just equals the marginal opportunity cost.
Notice that in the above set of rules for predicting a person's choices, we are implying that the marginal opportunity cost is measured (in a sense) in terms of the utility that could be obtained by doing some other activity or obtaining some other good instead. So, we are comparing utility gained with utility given up.
It may be useful to examine the "should you fix your car" example from chapter 2 in the Options and Outcomes book (summarized below).
While economics is not just about money, a money question can give some numbers so you can see what’s going on...
My car broke down. I had the car towed for $50, to a mechanic who charged me $400 to find out what was wrong. Notice, these expenses ($450 total) are in the past tense.
Now, I am told that to fix the car will cost an additional $1200 (beyond what I've already paid).
I find out that if the car is not fixed, it is worth nothing ($0)
If I fix the car, I can sell it for $1,400; this is also how much it would cost me to replace the car with a similar one. I can afford to fix the car, and the best use of the money I have is to somehow get some kind of car (either by fixing this one or replacing it). The car has no emotional or other value to me that is not included in the money values given above.
Should I fix the car?
The answer is YES. Why? That may not seem obvious, unless you apply the rules of marginal utility and marginal opportunity cost we outlined above.
Marginal Cost of fixing the car is $1,200 (the cost that is additional to the amount already spent)
Marginal Utility of fixing the car is $1,400 (based on the car being worth $0 if not fixed, but worth $1,400 if fixed, the increment or addition in value is $1,400, which can be obtained by fixing the car)
Thus, since the MU>MC, then do it (fix the car)
If MU<MC, then don’t do it
If MU=MC, stop doing it
The $450 is in the past, so it doesn't count as marginal. However, if you want to go through the extra work of including it, you can. It does not alter the conclusion though.
Suppose I don't want to keep the car, and want to instead get a completely different car. If I don't fix the car, I am out the $450 I have spent. Then, I call the junkyard to take the broken car away, but don't get a cent for it. So, $450 is missing from my bank account when I start looking for another car.
If I fix the car, I am still out the $450, and spend another $1,200. However, I can then sell the fixed car for $1,400. So, altogether, I get back $200 of the $450 I have already spent. Only $250 is gone from my bank account with this option, so I am better off if I fix the car rather than just having it hauled away. Now, this assumes that the $1,400 I get from the car when I sell it takes into account the costs of selling it. But, as long as all of that is in there, fixing the car is the best option.
Suppose I want to keep the car (or replace it with one just like it). If I don't fix the car, I am out the $450 I have spent. Then, I call the junkyard to take the broken car away, but don't get a cent for it. Then, I will need to spend another $1,400 to replace the car with a similar one. Altogether, I am out $1,850.
If I fix the car, I am still out the $450, and spend another $1,200. However, I then have the fixed car, and just keep it. So, altogether, it costs me only $1,650 to get a usable car. So, I am better off if I fix the car rather than replacing it. Plus, I know that the car I have won't need the same repair again, which is something I cannot know if I get a replacement car.