2. The marginal benefits of activities A and B are represented as follows: MB A

Question

2. The marginal benefits of activities A and B are represented as follows:

            MBA = z = 10 - x and MBB = z = 21 - 2y

Where z is marginal benefit per dollar, x is the amount spent on product A, and y is the amount spent on product B. Assume that the consumer has $10 to spend on A and B - that is, x + y = 10. (1) How is the $10 best allocated between A and B? (2) How much benefit will the marginal dollar yield? (10 points)

Hint: With regard to the first question, you are asked to solve for the value of the two variables, x and y. That means, you will need two equations (system of equations) to solve the problem. One of the equations can be derived from the optimization rule and the other from the budget constraint.

Explanation / Answer

Economists believe that consumers make decisions at the margin; i.e. should one more unit of the good be obtained or not? The consumer will compare the additional (marginal) utility to be achieved by consuming one more unit of the good, to the additional (marginal) utility that must be given up (buying power) in order to obtain the good. At any particular price, the consumer will continue to buy units of the good as long as the marginal benefit, as expressed by maximum willingness to pay, exceeds the price. The marginal benefit indicates, in dollar terms, what the consumer is willing to pay to acquire one more unit of the good; it can also be related to the height of an individual's demand curve. Another implication of the Law of Diminishing Marginal Utility is that the height of the demand curve will fall as more units of the good are consumed.

Another implication of marginal utility theory is that for consumers to maximize utility, the following relationship holds:

MUa = MUb = MUc = and so on...
Pa Pb Pc

MU refers to marginal utility of the good, P represents the price of the good, and the subscripts indicate a particular good. The last unit of each good purchased will provide the same marginal utility per dollar spent on that good.

The term marginal cost refers to the opportunity cost associated with producing one more additional unit of a good. Opportunity cost is a critical concept to economics - it refers to the value of the highest value alternative opportunity. For example, in examining the marginal cost of producing one more bushel of wheat, that number could be expressed as the dollar value of corn or other goods that could be produced in lieu of more wheat.

Marginal benefit refers to what people are willing to give up in order to obtain one more unit of a good, while marginal cost refers to the value of what is given up in order to produce that additional unit. Additional units of a good should be produced as long as marginal benefit exceeds marginal cost. It would be inefficient to produce goods when the marginal benefit is less than the marginal cost. Therefore an efficient level of product is achieved when marginal benefit is equal to marginal cost.

Consumer Surplus and Marginal Benefit
Consumer surplus represents the difference between what a consumer is willing to pay and the actual price paid. If a consumer is willing to pay $5.00 for a gallon of gasoline, and the actual price is $3.00, then there is a consumer surplus of $2.00 with the purchase of that gallon of gasoline. The value to the consumer, or marginal benefit, is $5.00. Value is calculated by getting the maximum price that consumers are willing to pay.

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