The idea of choice at the margin

Margin is the difference between the last and one extra unit. For example, marginal cost is the cost of producing one extra unit, and marginal utility is the extra utility/satisfaction a consumer receives from purchasing/consuming one more unit of a good.

Every decision about using scarce resources is made at the margin, which means the chooser weighs the extra benefit from a tiny increase in an activity against the extra cost that the same increase brings. When the extra benefit, which we call marginal benefit, is larger than the extra cost, which we call marginal cost, one more unit brings an improvement. When marginal cost is larger than marginal benefit, one less unit brings an improvement. The resting point is reached when marginal benefit is exactly equal to marginal cost, because any small move away from that balance would leave the chooser worse off than before. This marginal principle (the idea that economic agents may take decisions by considering the effect of small changes from the existing situation) is the organising rule for what follows, because it allows consumers to choose how much to buy, allows firms to choose how much to produce, and allows markets to coordinate everyone without central commands.

An idea that sits underneath every marginal calculation is opportunity cost. Resources can only be used in one way at a time, which means every choice gives up the best alternative use. The opportunity cost of a unit of output is the benefit that could have been earned from the best alternative output that the same resources could have produced. When a household spends on one more item, the opportunity cost is the value of the best other item that can no longer be bought. When a firm hires one more worker or runs a machine for longer, the opportunity cost is the value of the best other project or the best other use inside the business that must be postponed. Once opportunity cost is kept in view, the marginal principle becomes a practical rule that can be applied in small steps, which is exactly how real choices are made.

Rational decision making simply means that the chooser tries to reach the best position allowed by the available income, the available time, the available technology, and by the rules of the society in which the choice is made. No one needs advanced mathematics to be rational in this sense. The chooser only needs to ask whether the next small increase brings more benefit than cost, or whether the next small decrease saves more cost than benefit, and then repeat the adjustment until no improvement is possible. That is why the marginal principle is so central. It gives a concrete way to move choice toward an improving position and it gives a stopping rule that tells the chooser when to rest.

Utility, marginal utility, and the way total utility grows

To talk about benefits from consumption in a clear way, the text uses the idea of utility, which means the satisfaction a person gains from consuming goods or services within a period. The change in satisfaction that comes from adding one extra unit within that same period is called marginal utility. If we record both the level of total utility and the amount added by each extra unit, a regular pattern appears. The first unit brings a large rise in total utility, because some important need is met. The second unit still adds satisfaction, but the addition is smaller than the first. The third adds again, and the addition is smaller again. As the number of units rises, the extra satisfaction from the next unit tends to fall. This regular pattern is the law of diminishing marginal utility. The law does not say that people stop enjoying a good after one unit. It only says that the size of the extra gain falls as consumption mounts within the period.

A simple numeric sequence helps to make this concrete.

Imagine total utility after one unit is thirty units of satisfaction, after two units the total is fifty-six, after three units the total is seventy-seven, after four units the total is ninety-two, after five units the total is one hundred, and after six units the total is still one hundred. The increments that carry the total from one line to the next are the marginal utilities of each additional unit. They are thirty, then twenty six, then twenty one, then fifteen, then eight, then zero. The pattern in these numbers is the pattern the law describes. Marginal utility falls as the number of units rises, and total utility rises while marginal utility is positive, then becomes flat when marginal utility falls to zero, and can fall if too much is consumed.

This represents the law of diminishing marginal utility, which states that the more units of a good are consumed, the lower the utility from consuming those additional units

How a demand curve comes out of marginal utility

To turn satisfaction into a purchase decision, compare marginal utility with the money price of a unit. Think of marginal utility as if it could be measured in money units, which allows a direct comparison. A buyer chooses the quantity at which the marginal utility of the last unit taken is exactly equal to the price that must be paid for that unit. If marginal utility is above price, so an additional unit adds extra satisfaction above price "cost," one more unit improves the buyer’s position. If marginal utility is below price, purchasing one less unit improves the buyer’s position. The equality between marginal utility and price, therefore, identifies a unique quantity for each given price.

Now imagine the price is lowered while the person’s tastes and income are held constant.

The equality between marginal utility and price is then reached at a larger quantity, because marginal utility falls as quantity rises. Imagine the price is raised and keep everything else constant. The equality is then reached at a smaller quantity. If we list every possible price and the quantity that matches the equality at that price, and if we plot those pairs on axes with price vertically and quantity horizontally, the plotted points trace out a downward-sloping individual demand curve. The curve records the quantity a person is willing and able to purchase at each possible price while other influences on demand are held constant. The curve slopes downward because of the law of diminishing marginal utility, which is baked into the calculation that sets marginal utility equal to price.

Prices as signals and prices as incentives

A market price serves several purposes simultaneously. First, signalling, which means they adjust to demonstrate where resources are required, carrying information to buyers and sellers simultaneously. A buyer learns how much money must be given up for one more unit, which is the number that must be compared with marginal utility to decide the quantity to buy. A seller learns how much money can be received for one more unit, which is the number that must be compared with the marginal cost to decide the quantity to offer. Second, a market price serves as an incentive, as through choices consumers send information to producers about their changing nature of needs and wants. A higher price gives a buyer a reason to buy less, since the money outlay for the next unit has risen relative to the marginal utility of that unit. A higher price gives a firm a reason to produce more, since the revenue from the next unit has risen relative to the marginal cost of that unit. A lower price does the opposite, since it makes the next unit more attractive to buyers and less attractive to sellers. Through these paired reactions, prices move buyers along their demand curves and move firms along their supply curves until planned purchases and planned sales match. Finally, rationing, as prices ration (limit) scarce resources when demand outstrips supply. So that when there is a shortage, price is bid up in price, leaving only those with the highest willingness and ability to pay to buy.

Efficiency

Productive efficiency

Productive efficiency means maximizing output with the minimum input, or essentially, minimizing waste and using resources to their fullest potential. For a firm, this would mean operating at minimum cost, choosing an appropriate combination of inputs and producing the maximum output possible from those inputs.

We can also analyse an economy from the perspective of productive efficiency, to judge how well an economy uses its resources, begin with the production possibility curve.

This curve shows the maximum attainable combinations of two broad categories of output when all resources are fully employed and when producers use the best available methods. Therefore, every point on the curve is productively efficient because more of one good can be produced only by giving up some of the other good, so no extra output can be squeezed from the existing resources without a sacrifice. Every point strictly inside the curve is productively inefficient because it would be possible to raise the output of at least one category without reducing the other, which means some labour, capital or land is idle or misused. Every point outside the curve is unattainable given current resources and current technology. The curve is usually bowed outward, which means it is concave to the origin. That shape captures rising opportunity cost because as production is shifted further toward one category, resources that are less suited to that category must be pulled in from the other sector, so each extra unit of the favoured good requires a larger and larger sacrifice of the other good. The opportunity cost of the favoured good, therefore, rises as the economy moves along the curve.

Allocative efficiency

Using resources efficiently has two parts. The first part is to operate on the production possibility curve, which is productive efficiency. The second part is to choose the mix of goods on the curve that best matches consumer preferences, which is allocative efficiency. A clear decision rule identifies the allocatively efficient point. The economy is allocatively efficient when the value of the last unit of each good to consumers is exactly equal to the resource cost of producing that unit. Value at the margin is measured by willingness to pay for the last unit, which is the height of the demand curve at the traded quantity and is called marginal benefit. Resource cost at the margin is measured by the cost of producing one more unit, which is the height of the supply curve at the traded quantity and is called marginal cost. In a competitive market without artificial restrictions on entry or pricing, the equilibrium price equals both marginal benefit and marginal cost at the traded quantity. Price is the amount buyers pay for the marginal unit, so it measures marginal benefit, and price is the amount sellers receive for the marginal unit, so it reflects marginal cost. When the traded quantity sits where price equals marginal benefit and also equals marginal cost, no attainable reallocation can raise total benefit without raising total cost by at least as much. The mix of goods then aligns with preferences as expressed by demand, and the methods of production summarised by supply are the least cost methods for those outputs.

The same rule can be read on the production possibility curve. At any point on the curve, the slope shows how many units of one good must be given up to gain one more unit of the other good. This trade-off is the marginal rate of transformation. If a straight valuation line is drawn from the origin so that it just touches the curve at the chosen point, the slope of that line shows how willing society is to trade one good for the other on the margin, which reflects the balance of demand for the two goods given tastes and incomes. Allocative efficiency requires the slope of the production possibility curve to be equal to the slope of the valuation line at the chosen point, so the economy’s technical trade off matches society’s willingness to trade. Competitive markets deliver this equality by moving each market toward a position where price equals marginal cost at the traded quantity, which sets relative prices equal to the economy’s marginal transformation rate.

Economic efficiency

Economic efficiency is a situation in which both productive efficiency and allocative efficiency have been reached. Resources are fully used with current technology and the mix of goods matches the pattern of marginal benefits that consumers reveal through demand. It is important to distinguish this standard from equity, which concerns how income and wealth are shared among people. An outcome can be economically efficient while most resources are held by a few. A society may then choose to alter the distribution while preserving the price signals and incentives that support efficient production and exchange. Efficiency is about using scarce resources to generate the largest possible total benefit measured by willingness to pay. Equity is about how that total is divided.

For the price mechanism described here to work as stated, several background conditions must be in place. Property rights over resources and products must be secure so owners have reason to invest and maintain and so parties can trade with confidence. Entry and exit must be open so price is not kept above marginal cost by artificial barriers. Rules that underpin contracts and competition must be respected so collusion or coercion do not block the adjustments traced by the curves. When these foundations hold, a competitive market moves toward the position where price equals marginal cost and the two efficiency standards are satisfied. When these foundations are weak, the economy can fail to reach that position. Later analysis studies those departures, but the benchmark is fixed by the conditions set out above and provides the reference against which real outcomes can be assessed.