Optimization in Economics

Optimization in Economics is about making the best possible choice. In this article, the way this is done is demonstrated with scenarios and data.

Economists believe that optimization describes most of the choices economic agents make. However, people don’t always make the optimal choice. A large body of economic research attempts to answer the question: when do people succeed in choosing the best feasible option and when do they fail. Using the concept of optimization to describe and predict behavior is an example of positive economic analysis.

Optimization concepts also provide an excellent toolbox for improving decision making that is not already optimal. Optimization using total value has 3 steps: translate all costs and benefits into common units, calculate the total net benefit of each alternative, and pick the alternative with the highest net benefit.

Marginal analysis evaluates the change in net benefits when you switch from one alternative to another. Marginal analysis calculates the consequences of doing one more step of something. Marginal cost is the extra cost generated by moving from one alternative to the next alternative. Optimization using marginal analysis has 3 steps: translate all costs and benefits into common units, calculate the marginal consequences of moving between alternatives, and apply the principle of optimization at the margin by choosing the best alternative with the property that moving to it makes you better off and moving away from it makes you worse off.

Optimization using total value and optimization using marginal analysis yield the same answer.

Economists refer to the best feasible option as the optimal choice. Behavioral economics jointly analyzes the economic and psychological factors that explain human behavior.

Marginal analysis is a cost benefit calculation that studies the difference between one feasible alternative and the next feasible alternative. Marginal cost is the extra cost generated by moving from one feasible alternative to the next feasible alternative.

The principle of optimization at the margin states that an optimal feasible alternative has the property that moving to it makes you better off and moving away from it makes you worse off.