Element 1.3: Decisions Are Made at the Margins
“Great things are not done by impulse, but by a series of small things brought together.”
To get the most value from our scarce resources, economics provides a simple rule: pursue those actions that generate more benefits than costs; avoid those actions that generate more costs than benefits. This principle of sound decision-making applies to individuals, businesses, government officials, and society as a whole.
Nearly all choices are made at the margin. That means that they almost always involve additions to (or subtractions from) current conditions, rather than “all-or-nothing” decisions. The word “additional” is a substitute for “marginal”. We might ask, “What is the marginal cost of producing or consuming one more unit?” Marginal decisions may involve large or small changes. The “one more unit” could be a new shirt, a new house, a new factory, an additional investment, or even an expenditure of time, as in the case of a student choosing how to spend some more time among competing activities after pulling back from others. All these decisions are marginal because they involve consideration of additional costs and benefits.
People do not make “all-or-nothing” decisions, such as choosing between eating or wearing clothes. Instead, they compare the marginal benefits of a little more food, with the marginal costs of a little less clothing or doing without as much of something else. In making decisions individuals don’t compare the total value of food and the total value of clothing and choose one or the other. Rather, they compare their marginal values—a little more of one item and a little less of others. Incentives guide us to choose options only when their marginal benefits exceed the marginal costs.
Marginal decisions may also involve the costs and benefits of changes in the characteristics of what we buy or do. “Should I run an extra mile in my workout today?” “Do I want a three-bedroom house or a two-bedroom one?” “What about Nike shoes versus those from Walmart?” Similarly, a business executive planning to build a new factory will consider whether the marginal benefits of the new factory—for example additional sales revenues—are greater than the marginal costs—that is, the expenses of constructing the new building and the sacrifice of other things. If not, the executive and the company are better off without the new factory.
Effective political actions also require marginal decision-making. Consider the policy decision of how much effort and resources to put into cleaning up pollution. If asked how much pollution is acceptable, many people would respond “none.” In other words, pollution levels need to move to zero. In the voting booth they might vote that way. But marginal thinking reveals that this would be extraordinarily wasteful.
When there is a lot of pollution—so much, say, that we are choking on the air we breathe—the marginal benefit of reducing pollution is quite likely to exceed the marginal cost of the reduction. But as the amount of pollution goes down, so does the marginal benefit—the value of the additional improvement in the air. There is still a benefit to an even cleaner atmosphere (for example, we would be able to see distant mountains), but this benefit is not nearly as valuable as protecting our lungs. Before the pollution disappears 100 percent, the additional benefit of pollution reduction approaches zero.
As the marginal benefit of reducing pollution by an additional unit goes down, the marginal cost rises. As more and more resources are diverted away from other viable uses, the cost of cleaner air becomes higher. The marginal cost is the value of things that are sacrificed to reduce pollution a little bit more. Spending on health care, education, improved infrastructure, and other expenditures are but a few examples. They must be considered when evaluating the wisdom of reducing pollution to still lower levels. Once the marginal cost of a cleaner atmosphere exceeds the marginal benefit, additional pollution reduction is wasteful and counterproductive. It would simply not be worth the cost. The basic rule is “do the easiest things first!”
To continue with the pollution example, consider the following hypothetical situation: Assume that pollution is doing €100 million worth of damage, and only €1 million is being spent to reduce pollution. Given this information, are we doing too little or too much to reduce pollution? Most people would say that we are spending too little. This may be correct, but we need more information before drawing a conclusion.
The €100 million in damage is total damage, and the €1 million in cost is the total cost of cleanup. To make an informed decision about next steps, we need to know both the marginal benefit and the marginal cost of cleanup. If spending another €10 on pollution reduction would reduce damage by more than €10, then we should spend more. The marginal benefit exceeds the marginal cost. But if an additional €10 spent on antipollution efforts would reduce damages by only a dollar, additional spending would be unwise.
People commonly ignore the implications of marginalism in their comments and votes but seldom in their personal actions. Consider food versus recreation. When viewed as a whole, food is far more valuable than recreation because it allows people to survive. When people are poor and living in impoverished communities, they devote most of their income to securing an adequate diet. They devote little time and money, if any, to expensive pursuits like playing golf, waterskiing, or other recreational activities.
But as people become wealthier, the opportunity cost of acquiring food declines. Although food remains vital to life, they have can more than meet their basic needs so continuing to spend most of their money on more food becomes unnecessary. At higher levels of affluence, people find that at the margin—as they make decisions about how to spend each additional euro—food is often worth less than recreation. So as people become wealthier, they spend a smaller portion of their income on food and a larger portion of their income on recreation. Armenia and France are both renowned for their cuisine but in 2022 Armenian households, on average, spent 47% of their income on food while those in much wealthier France only spent 13.3% of their income on food.(5)
The concept of marginalism reveals that marginal costs and marginal benefits are relevant to sound decision-making. If we want to get the most value out of our resources, only actions for which the marginal benefits are greater than marginal costs must be undertaken. Both individuals and nations are more prosperous when personal and policy choices reflect the implications of marginalism.
Making decisions at the margin is tightly linked to time. Many decisions cannot be undone once made so are no longer relevant when making a decision at the margin. Once a plant is built, a producer can’t unbuild it. These costs are call “sunk costs” or “fixed costs.” In economic theory these costs should not affect making decisions about variable things such as how many workers to hire even if, in a world of time travel, the firm might not have chosen to build the plant at all. Similarly, individuals operate in a world where costs, once incurred, cannot be taken back. If a student spends time and tuition obtaining a degree in, say, sociology, those costs are sunk if she then discovers there are more or better paying jobs in tourism.