consider every outcome or loss a cost incurs due to choosing an action.
Both the costs and the benefits need to be evaluated to determine their magnitude. While monetary costs and monetary benefits come with a built-in measurement system, other kinds of costs and benefits have to be measured individually. In economics, the subjective value of a given good or service is the reservation price.1
A sunk cost is contrasted with an opportunity cost. A sunk cost is a resource that has either been allocated or lost regardless of a decision. In choosing one option, more than one thing might be forfeited. For instance, if three decisions are ranked first, second, and third, only one can be chosen. The opportunity cost of choosing first is losing second. Third would not have been chosen regardless of choosing first or second and is therefore the sunk cost. Forgoing other opportunities can only compare with the “second best” option as an opportunity cost, since all other options must be given up for the second best possibility anyway.
Benefits
Similar to costs, benefits are also viewed rather broadly in economics. Aside from the monetary benefits, every other conceivable benefit like happiness, friendship, health, or the potentially positive feeling of learning something new must be considered. Holistically, this is utility.2
Utility can quantify the inherent non-linearity of the perceived value gained from increasing the amount of any given good a consumer consumes. The first unit of consumption creates a large utility improvement. The additional utility of a second unit of consumption is less. This tendency of lowering additional gain from increased consumption is called diminishing marginal utility.3
It is important to note that nearly all goods, including money itself, have diminishing marginal utility. In case of production (as it is generally assumed to be done by some kind of corporate entity), there is more attention paid to monetary gains than to utility.
Marginalism
Whether money or utility is used, marginalism attempts to explain the change in value of products by reference to their secondary unit. In marketing, firms use the marginal approach to determine sensitivity of quantity sold with respect to price. The technique can be used in many fields and includes the following steps. First, make a small change. Then, observe the result. If the change improves total profit, make a similar change in the same direction. If the change reduces total profit, make a change in the opposite direction. This process repeats until total profit (or total utility) is maximized.
Marginal cost is the change in total cost when the manager above changes the production amount and similarly, marginal benefit is the change in total benefit when the manager changes the amount produced. In case of consumption marginal cost and benefit are the result in the change in the total cost and benefit due to a change in the consumption of the individual. The technique works similarly in a corporate setting, replacing marginal utility with marginal profit, when the question is optimal output amount.
This kind of marginal analysis works best when there is a single point where total profit is maximized. However, there can be several points where there is a local maximum which is different than the global maximum. Consider the chart shown in Figure 3 below:
Figure 3 Minima and Maxima.
Using a marginal analysis, the manager may believe that the local maximum is the global maximum if the changes made are sufficiently small. However, a larger sample of wider points might reveal that a much larger quantity creates a global maximum.
Incentives
In economics, the acts of establishing rewards or punishments for certain behaviors is called incentivizing and disincentivizing, and the reward itself is called an incentive; the punishment, a disincentive. Students who learn useful skills incentivize a firm to hire them—while the firm, that establishes the practice of hiring trained professionals, incentivizes students as they consider their directions of study. The remainder of this book focuses on how firms can create incentives to get people to purchase services (Chapter 4), goods (Chapter 5), pay bills (Chapter 6), work toward the employer’s best interests (Chapter 7), and form new firms (Chapter 8).
Introduction to Markets
In the market model, costs, benefits, and subjective valuation all play a part. In economics, a market is a place where buyers and sellers of a product meet. This might be a physical location, an on-line location, or just an abstract concept.
The market model is centered around the concepts of supply and demand. Supply describes the behavior of the sellers, demand the behavior of buyers. Both of these terms are defined for individuals as well as for entire markets. Individual demand describes a single buyer, while market demand is the aggregate of all buyers of the particular good or service.
Individual Demand
Individual demand shows how much of a given product a buyer is willing and able to purchase, which is dependent on the price of the product at the time of consideration. Higher prices make the consumer both (1) able to buy less of the product and (2) have to give up more consumption of other products for each unit of the given good consumed (the opportunity cost increases).4 This tendency of consumers to buy more of cheaper things is called the law of demand.5
Similarly, individual supply shows how much of a product a seller is willing and able to sell of a given product. The tendency for suppliers to increase the availability of their product is called law of supply.6
Case Problems
Alice’s individual demand for hamburgers is shown below.
How many hamburgers will Alice buy if the price is $7?
There is a sale and the price of hamburgers goes down to $5. How many will Alice buy now?
Bob sells hamburgers as shown in the figure below:
Figure 4 Alice’s individual weekly supply of hamburgers.
Figure 5 Bob’s individual weekly supply of hamburgers.
How many hamburgers will Bob make if the price is $4 each?
There is a hamburger boom, and the price goes up to $5 each. How many hamburgers will Bob make now?
Market Demand, Supply, and Equilibrium
When analyzing markets, the individual supplies and individual demands are aggregated. For each price, market demand shows the total amount that can be sold of a product, and market supply shows the total amount of the available product.7 Since market demand and supply are aggregates of individual demand and supply, the laws of demand and supply remain in effect. Because of the way the addition works, the price axis will not change either for demand or supply. The quantity axis, however, will expand dramatically.
Once individual demands and supplies are transformed to market demand and supply, their functions are comparable. Before the aggregation,