Thinking at the margin and incentives
Why good decisions compare the next bit of benefit with the next bit of cost, and how incentives change what people do.
FinanceEveryday economicsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Compare marginal benefit with marginal cost to make a decision
- Explain why water is cheap and diamonds dear
- Show how a policy can change behaviour through incentives
Builds toward: Run your own money. Budget so there's room to save, spot and clear costly debt, compare savings and loan offers, and see what interest and inflation do to your money.
Everyday economics: news, prices and choices: lesson 2 of 11
- Everyday economics
- Trade-offs and opportunity cost 5 min
- Thinking at the margin and incentives 5 min
- Models and the circular flow 5 min
- Positive and normative statements 6 min
- Demand and what shifts it 5 min
- Supply, equilibrium and shifts 6 min
- What money is 5 min
- What GDP counts 6 min
- Real and nominal GDP 5 min
- Measuring unemployment 5 min
- The costs of inflation 6 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 1
What it is
Principle 3: rational people think at the margin. Economists assume people try to do the best they can with what they have. Most real decisions are not all-or-nothing: the question is not "study or not" but "one more hour of study or not". A marginal change is a small adjustment to a plan, at its edge.
The rule: take an action if, and only if, its marginal benefit is greater than its marginal cost.
Mankiw's airline example. Flying a 200-seat plane costs the airline 100,000 dollars, so the average cost of a seat is 100,000 ÷ 200 = 500 dollars. Ten seats are still empty at take-off, and a standby passenger offers 300 dollars. Should the airline sell? Yes. The marginal cost of one more passenger on a plane that is flying anyway is tiny: little more than a snack and a soft drink. Any price above that adds to profit.
Quick check
Tap an answer to check it.
A cinema's costs average 8 per seat. Ten minutes before a film starts, half the seats are empty, and an extra viewer adds almost no cost. Someone offers 3 for a seat. Should the cinema accept, by marginal thinking?
- Average cost includes costs paid whether or not this person comes
Show answer
Yes: 3 is more than the tiny marginal cost. Compare the extra benefit with the extra cost, not with the average.
Why it matters
Water and diamonds. Water is essential and diamonds are not, yet diamonds cost far more. Mankiw's answer: what people will pay depends on the marginal benefit of one more unit. Water is plentiful, so an extra cup adds little; diamonds are rare, so an extra one is valued highly.
Principle 4: people respond to incentives. An incentive is something that leads a person to act, such as a reward or a penalty. Because people compare costs and benefits, a change in either changes behaviour:
- A higher price gives buyers a reason to buy less and sellers a reason to produce more.
- A tax on petrol encourages smaller cars, car-sharing and public transport; Mankiw notes that people drive smaller cars in Europe, where petrol taxes are high, than in the United States.
Unintended consequences. Policies can change incentives in ways their designers did not intend. Mankiw describes economist Sam Peltzman's 1975 study of car-safety laws: seat belts made each accident safer, but drivers may then drive less carefully. Peltzman's evidence pointed to fewer deaths per accident but more accidents, with little change in driver deaths and more pedestrian deaths. Mankiw calls it an offbeat and controversial example; the general lesson is to look for indirect effects through incentives.
The other six principles, for later lessons: trade can make everyone better off; markets are usually a good way to organise economic activity; governments can sometimes improve market outcomes; a country's standard of living depends on what it can produce; prices rise when the government prints too much money; and society faces a short-run trade-off between inflation and unemployment.
Worked example
You are deciding how many hours to revise for an exam. You estimate the extra marks each hour will bring, and value an hour of your time at the equivalent of 5 marks (what else you could do with it).
| Hour | Extra marks from this hour |
|---|---|
| 1st | 12 |
| 2nd | 9 |
| 3rd | 6 |
| 4th | 4 |
- Hours 1–3 each bring more than 5 marks: worth doing.
- Hour 4 brings 4, less than the 5 it costs: stop after 3 hours.
Each extra hour adds less than the one before, so the right amount is where the next hour stops being worth it, not "as much as possible".
Common mistake
Using average cost or benefit to make a decision at the margin. The airline's average cost per seat is 500, but the cost of filling an empty seat is almost nothing. Decisions about "one more" need the cost and benefit of one more.
Key terms
- rational
- systematically doing the best one can to reach one's goals with the options available
- marginal change
- a small adjustment to an existing plan
- marginal benefit
- the extra benefit from one more unit
- marginal cost
- the extra cost of one more unit
- incentive
- something that leads a person to act, such as a reward or penalty
Practise the key terms
Tap a card to turn it over. 5 cards.
| Front | Back |
|---|---|
| rational | systematically doing the best one can to reach one's goals with the options available |
| marginal change | a small adjustment to an existing plan |
| marginal benefit | the extra benefit from one more unit |
| marginal cost | the extra cost of one more unit |
| incentive | something that leads a person to act, such as a reward or penalty |
Practice
Work it through
A bakery's costs for a day average 2.00 per loaf over 100 loaves. At closing time 10 loaves are left; baking them is already paid for. A customer offers 0.80 each for all 10.
- Total cost ÷ 100 loaves
- It is already baked; nothing extra is spent
- 10 × 0.80
Quick quiz
Tap an answer to check it.
In the last exercise, should the bakery sell?
- The average includes costs already paid
Show answer
Yes: 8 more than it would otherwise get, at no extra cost. Marginal benefit (0.80 a loaf) beats marginal cost (nothing).
Why are diamonds dearer than water, in Mankiw's explanation?
- Water is essential; it is the extra unit that matters
Show answer
An extra diamond is valued more, because diamonds are rare and water is plentiful. Willingness to pay depends on the marginal benefit of one more unit.
What did Peltzman's study suggest about car-safety laws?
- His evidence showed effects through drivers' behaviour
Show answer
Fewer deaths per accident but more accidents, with more pedestrian deaths. The laws changed drivers' incentives to drive carefully.
In short
- Rational people compare marginal benefit with marginal cost.
- Average cost can mislead a "one more" decision.
- Value depends on the marginal unit: water and diamonds.
- People respond to incentives, so policies can have indirect, unintended effects.
Mastery check
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Check yourself
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What is the decision rule at the margin?
Show answer
Act if, and only if, the marginal benefit is greater than the marginal cost.
In Mankiw's airline example, what is the average cost of a seat?
Show answer
500 dollars (100,000 ÷ 200).
What is an incentive?
Show answer
Something that leads a person to act, such as the prospect of a reward or a punishment.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 1.
- On this site: Trade-offs and opportunity cost.
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