PRINCIPLE 3: RATIONAL PEOPLE THINK AT THE MARGIN

PRINCIPLE 3: RATIONAL PEOPLE THINK AT THE MARGIN

Economists normally assume that people are rational. Rational people systematically and purposefully do the best they can to achieve their objectives, given the opportunities they have. As you study economics, you will encounter firms that decide how many workers to hire and how much of their product to  manufacture and sell to maximize profits. You will encounter consumers who buy a bundle of goods and services to achieve the highest possible level of satisfaction, subject to their incomes and the prices of those goods and services.

Rational people know that decisions in life are rarely black and white but usually involve shades of gray. At dinnertime, the decision you face is not between fasting or eating like a pig but whether to take that extra spoonful of mashed potatoes. When exams roll around, your decision is not between blowing them off or studying 24 hours a day but whether to spend an extra hour reviewing your notes instead of watching TV. Economists use the term marginal changes to describe small incremental adjustments to an existing plan of action. Keep in mind that margin means “edge” so marginal changes are adjustments around the edges of what you are doing. Rational people often make decisions by comparing marginal benefits and marginal costs.

For example, consider an airline deciding how much to charge passengers who fly. standby. Suppose that flying a 200-seat plane across the United States costs th~ airline $100,000. In this case, the average cost of each seat is $100,0001200, which is $500. One might be tempted to conclude that the airline should never sell a ticket for less than $500. In fact, however, the airline can raise its profits by thinking at the margin. Imagine that a plane is about to take off with ten empty seats, and a standby passenger waiting at the gate will pay $300 for a seat. Should the airline sell the ticket? Of course it should. If the plane has empty seats,the cost of adding one more passenger is minuscule. Although the average cost of flying a passenger is $500, the marginal cost is merely the cost of the bag of peanuts and can of soda that the extra passenger will consume. As long as the standby passenger pays more than the marginal cost, selling the ticket is profitable.

Marginal decision making can help explain some otherwise puzzling economic phenomena. Here is a classic question Why is water so cheap, while diamonds are so expensive: Humans need survive. while diamonds are unnecessary but for some reason, people are willing to pay much more for a diamond than for a cup of water. The reason is that a person’s willingness to pay for any good is based on the marginal benefit that an extra unit of the good would yield. The marginal benefit, in turn, depends 01. how many units a person already has. Although water is essential, the marginal benefit of an extra cup is small because water is plentiful. By contrast, no one needs diamonds to survive, but because diamonds are so rare, people consider the marginal benefit of an extra diamond to be large.

A rational decision maker takes an action if and only if the marginal benefit of the action exceeds the marginal cost. This principle can explain why airlines are willing to sell a ticket below average cost and why people are willing to ray more for diamonds than for water. It can take some time to get used to the logic of marginal thinking, but the study of economics will give you ample opportunity to practice.

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