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  • Writer's pictureRachana Kadikar

How to Make Decisions - Marginal Analysis, Opportunity Cost, and Tradeoffs

Welcome to the first post on MoneyPlanet! Today we will be discussing very basic, but important concepts that can help you make better decisions.

One of the first concepts taught in an economics class is marginal analysis. Marginal analysis is the decision making system in which you can analyze the marginal benefits and marginal costs of doing one more thing, hence the word marginal. Keep in mind, this is not just a pros and cons list.

For example, imagine that you are at a restaurant with unlimited soda drinks. The first drink carries many marginal benefits - it quenches your thirst, it is pleasing to the appetite, and many more. In addition, it carries very few marginal costs - it is free of charge, a little bit of sugar and unhealthy drink won't cause too many problems, and it doesn't mess with your appetite for other food or bathroom habits. The marginal benefits outweigh the marginal costs for the first drink. Now you finish your first drink and you have to make the decision whether or not to refill your drink. Marginal benefits of a second drink - thirst quenching (to a lesser extent), still pleasing to the appetite (again to a lesser extent), etc. We see that the marginal benefits have reduced from the first drink to the second drink. We will get to this idea later on. When we consider the marginal costs of the second drink, we can see that they have increased from the marginal costs of the first drink - there can be worse health costs of drinking additional soda, and it can make you have to pee and fill you up with little space for the actual food at hand. Each additional drink that you would consume would come with decreasing marginal benefits, and increasing marginal costs.

Okay, now that we've learnt about the basic idea of marginal benefits and marginal costs, you might be thinking, well how do we know when to stop making the decision to take the additional drink? The answer is again very simple. You would continue to partake in the additional actions as long as the marginal benefits outweigh the marginal costs. Once the marginal costs exceed the marginal benefits, you should stop with the action. Although you have access to unlimited drinks, doesn't mean you should drink as much as you possibly can. You want to maximize your benefit, and minimize your costs, and using marginal analysis can help you do just that.

This idea of decreasing marginal benefits with each additional unit is known as the law of diminishing marginal returns.

You can see this idea of diminishing marginal returns in almost every decision you make in your life. For example, deciding whether to sleep for another hour or not, deciding how many cups of coffee to drink, deciding how much time to spend studying, deciding how many people to invite to a birthday party, etc. Becoming aware of the marginal benefits and costs can help you make better decisions for yourself.

Now that we have discussed marginal analysis, I want to shift your attention now to something very similar and still very important. In discussing marginal analysis, we face the choice whether to engage in another action or not. We have several options in every choice and decision we must make, and that is where the idea of the opportunity cost and trade-offs come into play.

Trade-offs - every other decision that could be made that you give up when you decide to do something.

For example - deciding to sleep for an extra hour in the morning means you give up an hour of studying, an hour of exercise, an hour of watching TV, an hour of scrolling through social media, an hour of school or work, an hour of making breakfast, and many more things.

Now obviously, not all of these things are equally appealing or useful to you. That is where opportunity cost comes into play.

Opportunity cost - the next best option given up when you make a decision.

For example, for me, deciding to sleep an extra hour today meant that I gave up on an hour of finishing my school work due tomorrow. This was the next best option for me, and therefore it is my opportunity cost.

Next time you have to make a decision, think of your trade-offs and your opportunity cost and decide which one you would rather give up. I promise, it can make decision-making a whole lot easier.


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