10/11/11

How to calculate marginal costs and benefits (from total costs and benefits), and how to use that information to calculate equilibrium


This example problem goes over the degree of comfort experienced at different levels of clean air.  The different dollar value amounts are shown for every 10% increase in clean air.  We want to find the optimum amount of clean air that we should have in this area, and it is important to remember that there is an optimal amount of pollution.  Having 100% clean air is probably never going to be the solution.

So the first step is to recognize the type of data we are working with.  In this problem we have a table of information showing us what the benefits and costs are for different levels of clean air. 
As we would expect, the more clean air we have in our economy, the higher the benefit we receive (we prefer clean air over dirty air).  However, as we produce (or clean) more of the clean air we also incur a cost.  As more clean air is present, the higher our costs. Note that benefits here is the same as utility,

% of Clean Air
Total Benefits
Total Cost
0%
0
0
10%
50
45
20%
130
50
30%
205
58
40%
269
68
50%
319
81
60%
351
96
70%
371
115
80%
386
150
90%
398
200
100%
406
280

The next logical step is to calculate the marginal benefits (marginal utility), and marginal costs.  In order to do this we should begin at 0% clean air.  When we move to 10% clean air, we see that benefits go up by 50, and costs go up by 45.  This means that our marginal benefit from 10% clean air is 50, and our marginal cost of 10% clean air is 45.  When we move from 10% to 20% we see total benefit change from 50 to 130.  This means that marginal benefit from another 10% increase in clean air (from 10% to 20%) is 80 (130-50).  The increase in cost is 5 (50-45) which is also our marginal cost.  We can do these calculations all the way through and we will end up with the following table:

% of Clean Air
Total Benefits
Total Cost
Marginal Benefits
Marginal Cost
0%
0
0


10%
50
45
50
45
20%
130
50
80
5
30%
205
58
75
8
40%
269
68
64
10
50%
319
81
50
13
60%
351
96
32
15
70%
371
115
20
19
80%
386
150
15
35
90%
398
200
12
50
100%
406
280
8
80

You can see that marginal costs are rising as more clean air is produced, and that marginal benefits are decreasing as more clean air is produced.  This result is consistent with the theory of diminishing marginal utility (for marginal benefits), and diminishing marginal returns (for increasing marginal costs).

If we graph out the marginal costs and marginal benefits, we will get our typical looking supply and demand graph where marginal costs represent supply (supply of c lean air) and marginal benefits represent demand (demand for clean air).


Now there are two ways to find the optimum amount of clean air.  The most basic economic way is to figure out where marginal benefits equal marginal costs.  In our table above, they are never perfectly equal, but at 70% clean air, we see that marginal benefit is 20, and marginal cost is 19.  This is pretty close, and since MB are greater than MC then this is a valid solution.  The true answer will probably be around 71% but 70$ is pretty close. 

Another way to do it is to find the difference between total benefits and total costs and choose the biggest number.  Theoretically either method will give us the same result so let’s find out:

% of Clean Air
Total Benefits
Total Cost
Net Benefit
0%
0
0
0
10%
50
45
5
20%
130
50
80
30%
205
58
147
40%
269
68
201
50%
319
81
238
60%
351
96
255
70%
371
115
256
80%
386
150
236
90%
398
200
198
100%
406
280
126

As you can see, our 70% clean air level gives us the highest net benefit.  Although it is only 1 higher than the 60% clean air level, it is higher.  This result is consistent with our MB = MC analysis so we should be confident that 70% clean air is the correct amount for this economy.

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