Tuesday, August 29, 2006

Econ101: Marginal and Relative Analysis

Economists -- at least your Café economists here -- don’t really care about big changes. We are into details. Meaning, we are more interested in small changes. What happens if I blog one more hour? Am I still as good as the last entry? How many minutes do I need to write one more posting? What do I have to sacrifice, in minute-equivalent?

People make decision based on marginal analysis. No? Well, yes, although you might not realize it. Remember when you were eating nasi goreng and chicken nuggets? You took a portion of nasi goreng and some, say four pieces of nugget. Then you were running out of the nasi while you still had one nugget remaining. And you were not full yet. So you decided to add nasi -- just enough to go with the lonely nugget. Then you’re satisfied. Sounds trivial. But congratulations, you just ran a marginal analysis. The “just enough” is the key there.

Still remember our first discussion? Yes, we talked about cost and benefit. We said, people do something when the total benefit of doing it outweigh the total cost. How does that relate to our marginal analysis? Here is the mantra: You do not stop doing whatever you are doing until the “marginal benefit” equals “marginal cost”. (At this point I’m tempted to use graphs and math – much easier; but let’s just talk – more fun).

You are doing two things at the same time.1 You’re assigned to organize a seminar. It is time now to call participants. But as usual, you just activated your yahoo messenger – you are now e-chatting with that cute someone out there. We can look at this from either side: your calling the seminar participants or your chatting with that guy. Believe me, the result will be exactly the same, but let’s just take the latter.

What is the cost of your chatting? This is the time you’re supposed to apply your opportunity cost concept. Yes, the cost of your chatting is the next best alternative use of your time. Since you have to work to earn money, the "cost" here is therefore the number of calls you don’t do. Now let’s do the game. If writing one more sentence to him and making one less call to participants makes you happier, you will rationally delay the call and do the chatting. You will keep doing this until you start “feeling guilty” of not doing your work (calling seminar participants).2 Until you are indifferent between chatting and calling. The additional pleasure of chatting is fully compensated with a guilty feeling of not-calling. Economists call this a situation where “marginal benefit equals marginal cost” (Forgive my abbrev: MB = MC). Since you will keep chatting if the marginal benefit of chatting outweighs the marginal cost of chatting (or: You will keep calling if the marginal benefit of calling exceeds the marginal cost of calling – See? It runs both ways!), this state of “MB = MC” is therefore optimal.3

Now I’d like to add one more thing. We prefer relative- to absolute measures. Everything absolute that stands alone (that is, without benchmark) is useless.4 We are impatient with people talking in absolute tones: “What is the 2005 Indonesian GDP?”,5 “How much is the Manager’s salary?”, “What are we good at?”, or “How many Indonesians are poor?”. Rather, we ask: “What is the growth rate of Indonesian economy?”, “How much raise did the Manager get?”, “What is our comparative advantage against Malaysia?”6, or “What is the poverty rate now?”. Relative analysis allows you to mentally picture what is really going on.

Stay tuned.

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1 Of course, in super marginal world, you can’t really do two things at really the same time. Only that guy in StarTrek can do that.

2 This is a term to actually say, your cost is increasing.

3 More on this yet another key concept, later. (Man, I keep promising…Sorry...)

4 Of course, two absolutes qualify for a comparison, which is good enough.

5 GDP stands for gross domestic product. It is also called national output, national expenditure, or national income. Please be patient with this confusion. More on this later.

6 Saying something like “Indonesia has a comparative advantage in palm oil” is meaningless. Compared to whom?