Optimizing Your Decisions in Economics
These are my notes and thoughts on optimizing your decisions in economics.
When an economic agent chooses the best feasible option, he is optimizing. Optimization using total value calculates the total value of each feasible option and then picks the option with the highest total value. Optimization using marginal analysis calculates the change in total value when a person switches from one feasible option to another, and then uses these marginal comparisons to choose the option with the highest total value. Optimization using total value and optimization using marginal analysis give identical answers.
Economists use optimization to predict most of the choices that people, households, businesses, and governments make. Optimization is often quite complex.
Behavioral economics explains why people optimize in some situations and fail to optimize in others. When people have self-control problems, optimization is not a good description of behavior.
In normal cost-benefit analysis, the decision maker finds the alternative with the highest value of net benefit, which is benefit minus cost.
Optimizing using total value has three steps:
- Translate all costs and benefits into common units, like dollars per month
- Calculate the total net benefit of each alternative
- Pick the alternative with the highest net benefit
Optimization using marginal analysis is often faster to implement than optimization using total value, because optimization using marginal analysis focuses only on the ways that alternatives differ. Optimization using marginal analysis breaks an optimization problem down by thinking about how costs and benefits change as you hypothetically move from one alternative to another.
Economists use the word marginal to indicate a difference between alternatives, usually a difference that represents one step or more. A cost-benefit calculation that focuses on the difference between one feasible alternative and the next feasible alternative is called marginal analysis. Marginal analysis compares the consequences of doing one step more of something.
Marginal analysis forces us to focus on what is changing when we compare alternatives. Since marginal analysis always picks out the same optimum as minimization of total cost, you can use whichever method is easier for the particular problem that you are analyzing. However, economists mostly use marginal analysis. Optimization at the margin is simple because you can ignore everything about two alternatives that are being compared except the particular attributes that are different. Marginal analysis reminds you to exclude information that is not relevant to your decision.
To sum up, marginal analysis has three key steps:
- Translate all costs and benefits into common units, like dollars per month
- Calculate the marginal consequences of moving between alternatives
- 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.
Marginal analysis can be used to solve any optimization problem. Marginal analysis is most commonly used when there is clear sequence of feasible alternatives.