• Social Scientist

Decision-Making Process

Theme 1: Introduction to Economics

Topic: Decision-making process

Relevance: H1 and H2 Economics

Introduction:

Rational economic agents use the marginalist approach during their decision-making process by weighing the marginal costs and benefits of an action. The marginal benefit of an action is the additional benefits derived from taking that action. The marginal cost of an action is the additional cost incurred from taking that action.

Consumers

The default objective of consumers is utilitiy maximization or the maximisation of utility. For consumers, the marginal benefit is marginal utility while the marginal cost is price of an additional unit of good or service


In the pursuit of maximisation of utility, consumers will only consider their private marginal benefits (PMB) and private marginal cost (PMC) and consume to the level where PMB = PMC at Qp as shown in Figure 1.


Figure 1: PMB=PMC

When PMB > PMC at any point below Qp, for every additional unit consumed, consumers net benefits or utility will increase, therefore consumers will consume an additional unit until PMB = PMC at Qp.


When PMB < PMC at any point beyond Qp, for every additional unit consumed, consumers net benefits or utility will decrease, therefore consumers will consume lesser unit(s) until PMB = PMC at Qp.

Producers (or firms)

The default objective of producers is profit maximization or the maximisation of profits. For producers, the marginal benefit is marginal revenue while the marginal cost is marginal cost of production


In the pursuit of maximisation of profits, firms will only consider their marginal revenue (MR) and marginal cost (MC) and produce to the level where MR=MC at Qp, where MC is rising as shown in Figure 2.


Figure 2: MC=MR

When MR > MC at any point below Qp, for every additional unit produced, producers net profits will increase, therefore producers will produce an additional unit until MR=MC at Qp .


When MR < MC at any point beyond Qp, for every additional unit produced, producers net profits will decrease, therefore producers will produce lesser unit(s) until MR=MC at Qp.

Governments

The default objective of governments is social welfare maximization or the maximisation of social welfare. For governments, the marginal benefit is marginal social benefit while the marginal cost is marginal social cost.


In the pursuit of maximisation of social welfare, governments aim that all goods and services be produced and consumed where social marginal benefits (SMB) and social marginal cost (SMC), when SMB=SMC at Qs and there will be allocative efficiency as shown in Figure 3.


Figure 3: SMC=SMB

When SMB > SMC at any point below Qs, there will be a deadweight loss as society’s welfare are not maximised. For every additional unit consumed or produced, society’s net welfare will increase. Therefore, government would want to intervene to increase the market output/quantity to until SMB = SMC at Qs.


When SMB < SMC at any point beyond Qs, there will be a deadweight loss as society’s welfare are not maximised. For every lesser unit consumed or produced, society’s net welfare will increase. Therefore, government would want to intervene to decrease the market output/quantity to until SMB = SMC at Qs.

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