Question

Risk Management and Insurance 2nd Edition Chapter 11 Problem 1 Solution. Can you explain how to do this problem? How did you come up with the marginal cost and marginal benefit numbers?

Thank you,

Sam

Answer 1

Microeconomics - Marginal Benefit and Marginal Cost

Within this section we will focus on determining the difference between marginal benefit and marginal cost, as well as how to calculate the efficient quantity.

Consumer Choice
Economic analysis generally assigns the following properties to consumers:

• Consumers make rational decisions. If two products are of equal benefit to a consumer, then he or she will choose the cheaper product. If two products are the same price, the consumer will choose the one that provides the higher benefit.

• Limited income enforces choice. Consumers have to make choices as to what goods will be purchased or not purchased. Purchasing one item means that less funds are available to purchase other items.

• Substitution of goods. Consumers can achieve satisfaction, which is generally referred to asutility, with many choices. The satisfaction and cost of a cheeseburger can be evaluated in comparison to other goods - such as hot dogs.

• The Law of Diminishing Marginal Utility. This law refers to marginal utility, which describes the increase in satisfaction from consuming one additional unit of the good. The Law of Diminishing Marginal Utility states that as each additional unit of a good is consumed, the amount of marginal (incremental) utility will decrease.

Economists believe that consumers make decisions at the margin; i.e. should one more unit of the good be obtained or not? The consumer will compare the additional (marginal) utility to be achieved by consuming one more unit of the good, to the additional (marginal) utility that must be given up (buying power) in order to obtain the good. At any particular price, the consumer will continue to buy units of the good as long as the marginal benefit, as expressed by maximum willingness to pay, exceeds the price. The marginal benefit indicates, in dollar terms, what the consumer is willing to pay to acquire one more unit of the good; it can also be related to the height of an individual's demand curve. Another implication of the Law of Diminishing Marginal Utility is that the height of the demand curve will fall as more units of the good are consumed.

Another implication of marginal utility theory is that for consumers to maximize utility, the following relationship holds:

MU_a = MU_b = MU_c = and so on...
P_a P_b P_c

MU refers to marginal utility of the good, P represents the price of the good, and the subscripts indicate a particular good. The last unit of each good purchased will provide the same marginal utility per dollar spent on that good.

The term marginal cost refers to the opportunity cost associated with producing one more additional unit of a good. Opportunity cost is a critical concept to economics - it refers to the value of the highest value alternative opportunity. For example, in examining the marginal cost of producing one more bushel of wheat, that number could be expressed as the dollar value of corn or other goods that could be produced in lieu of more wheat.

Marginal benefit refers to what people are willing to give up in order to obtain one more unit of a good, while marginal cost refers to the value of what is given up in order to produce that additional unit. Additional units of a good should be produced as long as marginal benefit exceeds marginal cost. It would be inefficient to produce goods when the marginal benefit is less than the marginal cost. Therefore an efficient level of product is achieved when marginal benefit is equal to marginal cost.

Consumer Surplus and Marginal Benefit
Consumer surplus represents the difference between what a consumer is willing to pay and the actual price paid. If a consumer is willing to pay $5.00 for a gallon of gasoline, and the actual price is $3.00, then there is a consumer surplus of $2.00 with the purchase of that gallon of gasoline. The value to the consumer, or marginal benefit, is $5.00. Value is calculated by getting the maximum price that consumers are willing to pay.

We expect consumers to continue purchasing units of a good as long as the marginal benefit exceeds the price paid; i.e., as long as there is a consumer surplus to be achieved.