Thinking on the Margin
We base our financial decisions on the expected benefits and costs. For example, we buy a car for transportation needs. We buy a home for shelter, security, and comfort. These benefits are hard to measure, but since they are essential needs, we give little thought to the costs of satisfying them.
Using a personal budget, we can easily measure the costs of owning a car or home: we know our monthly payment and how much we pay for insurance, taxes, and maintenance.
Cost-benefit analysis can be used to explain how we consume. First, the analysis attempts to measure the costs and benefits. If costs exceed benefits, buying is not a good idea. If benefits exceed costs, buying is a good idea since you gain a net benefit. Naturally, we want the most benefit for a given cost, the "biggest bang for the buck." Alternatively, we want to incur the lowest cost for a given amount of benefits.
Over time, the benefits we derive from additional consumption start to fall. As we consume each additional unit, the benefit we derive is less than what was derived from the previous unit. Economists call the incremental benefit we receive from the next unit of consumption the marginal benefit.
Similarly, the costs we incur from additional consumption start to rise with each additional unit. As we consume each additional unit, the cost is more than what was derived from the previous unit. Economists call the incremental cost we incur from the next unit of consumption the marginal cost.
As consumers, we seek to add benefits until the incremental benefit is equal to the incremental cost. Shown as lines on a graph, marginal benefits slope downward and marginal costs slope upward. The intersection of the lines is the amount we decide to consume. In other words, we consume an amount where marginal benefit equal marginal cost. This view is a cornerstone of economic theory used to describe consumer behavior.
Left of the point of intersection, marginal benefits are greater than marginal costs. To the right of the point of intersection, marginal costs are greater than marginal benefits.
It's not always easy to measure your benefits. However, we can attempt to use a simplified example. The following table shows marginal benefit and marginal cost the Thomases face when buying three cars over a span of several years:
Mr. and Mrs. Thomas decide to buy a new car for $10,000. They estimate the car will provide them with $12,000 in benefits (convenience, essential transportation needs) over the time they own the car. A few years later, they give the car to their child and buy a $20,000 car. Since their income has risen and they value their personal time even more, they decide the new car will provide $21,000 in marginal benefits. Since they receive no trade-in value on the current car, the marginal cost is $20,000.
Five years later, the Thomases give their second car to another child and shop for a third car. They are enamored of one particular car but dismayed by the $30,000 price tag. They decide the marginal benefit from the car is $25,000, or $5,000 less than the marginal cost. The Thomases choose to not buy the car. Instead, they find a substitute that will provide them with $25,000 worth of benefits.
In other words, the Thomases consume at the point where their marginal benefits equal marginal costs. Clearly, the hard part of cost-benefit analysis is measuring such intangible benefits as convenience and comfort. However, this example illustrates the basic decision-making process the Thomases go through.
Identifying and measuring, as best as possible, your marginal benefit and marginal cost helps in making financial decisions. Your personal budgeting skills will improve as you measure the costs of a financial decision. You will also think more carefully about the affordability of some purchases. Assigning a dollar value to your desires will help measure the marginal benefits.
The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.