Making Economic Decision

In the most basic level, the third stage of the choice model is not anything else but a cost beneficial analysis. In the first stage a person would evaluate how happy each one of the options would make him or her feel, measuring the level of corresponding utility. In the second, a person will determine restrictions and cost opportunity in each option. In the third a person would simply choose the option of which the benefits overcome the costs with the bigger margin.

The cost beneficial model of how people make decisions is very powerful because it seems to describe the process correctly. But this version of the analysis of cost beneficial can only say if people choose a determined option. In other words, it is only useful to describe decisions of everything or nothing, like eating chocolate or not eating it.

A much more powerful version of the analysis of cost benefit uses a concept called marginal utility to tell you not only if I am going to eat chocolate, or not, but also how much of it I am going to eat.

In order to see how marginal utility works, accept that the amount of utility that a determined good reports generally depends on how much of the good you have received from a person. Lets say for example that you are very hungry the first hamburger you eat will be very useful to you; the second one is also nice, but it is not as good as the first because you are no longer as hungry as you were before; the third hamburger is much less useful and if you were to continue eating you would probably find that the tenth one simply makes you sick.

Economists refer to this phenomenon as diminishing marginal utility. Each extra hamburger you eat is less useful then the one before it, in other words extra utility, or marginal utility, than each additional portion provides diminishes as you eat more and more portions.

In order to understand how diminishing marginal utility predicts decision making over the amounts of goods that are consumed, suppose you have $10 to spend in hamburgers or French fires. Suppose besides this, that each hamburgers costs $2 and that each portion of fries also costs $2.

Economists suppose that the objective of people that have a limited budget is adjusting the amount they can consume of each good in order to maximize their total utility. In this example since we are aware that the marginal utility of the hamburger diminishes quickly with each additional one, we would not want to spend the whole $10 on the hamburgers, since the fourth or fifth one would no longer provide much marginal utility. It would probably be wise to spend part of the budget on a hamburger and on some fries.

If a person were only to buy 4 hamburgers, he or she could then put aside $2 to spend on a portion of fries. Since it would be the person’s first portion, eating it would probably contribute a lot of marginal utility. If the marginal utility obtained from that first hamburger exceeds the marginal utility lost by not buying the fifth hamburger, then a person will definitely make the change. He or she will continue adjusting the amounts until they find the combination that maximizes the total utility he or she can buy with the $10.

Due to the fact that different people have different preferences, generally the amounts of each good that maximizes the total utility of each person are different. A person that absolutely loves hamburgers will spend on his or her $10 on that, while a person that likes fries will spend his or her $10 on that. There are also people that prefer a bit of both and in these cases the optimum amount of each one depends on their opinions about the two goods and how quickly it decreases their marginal utilities.