So how many slices of pizza will Jane buy in this situation?
If Jane’s decision is best made by using marginal analysis, then we must consider
how each individual slice of pizza is valued by Jane and then compare that value to
the pizza’s cost. Let’s assume Jane is an honest person and that she has no reason
to lie when asked how much she’d be willing to pay for each slice of pizza (this is
obviously not a realistic assumption if the question’s being asked by the seller).
Our forthcoming analysis is simple, we’ll ask a pair of questions before Jane
purchases each slice of pizza. Question #1 is directed at Jane "How much would
you be willing to pay for this slice?" Question #2 is something we’ll ask
ourselves, "If that slice is $2, then will Jane buy it?"
How much is that first slice worth? Jane says she’s quite hungry and would really like
some pizza, so she’d be willing to pay up to $4 for that slice. Because the slice only
costs her $2, she’ll obviously want to buy it. After eating the first slice of pizza,
Jane considers a second. How much is the second slice worth? Jane’s still hungry,
but obviously not as hungry as before the first slice. Consequently, that second slice
isn’t worth as much to Jane. Her answer is that she’d be willing to pay up to $3 for
a second slice of pizza. Will she buy it? Again, as before, a person will always
purchase something if they know they’ll derive greater gain from that purchase than
they give up in cost. Jane will buy a second slice of pizza.
After two slices of pizza, Jane’s starting to feel a little full. She’d only be willing to pay $2 for a third slice. Compared with the $2 cost, however, our logic above leads us to conclude that she’d still buy a third slice of pizza. The fourth slice of pizza is another story. Jane could eat a fourth slice, but it would leave her feeling very full, something she doesn’t like to do very often. How much would she be willing to pay for that fourth slice? She replies that she’d be willing to pay 50 cents for it, but no more. Will she buy four slices of pizza? No, Jane wouldn’t be behaving very rationally if she purchased a $2 slice of pizza that she only thought was worth 50 cents. Let's record this information in a table (below).
Why does Jane buy 3 slices of pizza and not 4 slices? The obvious answer is
that as long as Jane doesn't experience any reductions in net benefit, she'll
continue buying pizza slices. This implies that she'll continuing purchasing
until she buys 3 slices, but will stop before the fourth slice because that
fourth slice makes her worse off.
Looking at the table, we can make a couple additional, more formal points. Note
first that the benefit from each successive slice of pizza gets less and less.
That is, note that the marginal benefit associated with each slice is decreasing.
This corresponds with what we call the Law of Diminishing Marginal Utility (or
returns). Diminishing marginal returns does not imply that Jane should stop buying
pizza slices at any specific point, but does imply that this stopping point will
eventually occur since Jane consumes until the marginal benefit and marginal cost
are equal.
Another point concerns the net benefit derived from each slice. Although Jane is
willing to pay $4 for the first slice of pizza, she only has to pay $2. In a sense,
Jane has saved money. We call this type of saving Consumer Surplus, and it
represents the difference between the most one is willing to pay and what one
actually does pay (summed up for all units purchased). The more consumer surplus
Jane acquires, the more benefit she derives from her consumption.
By graphing this information, it’s possible to see all of this framed in a
slightly different manner. The benefit from each slice is
measured in terms of the willingness to pay for each slice, and the cost of each
slice is measured in terms of the price of each slice. This dollar amount per slice
is represented by movement up the vertical axis. The horizontal axis identifies the
number of the slice we’re looking at (e.g. whether it’s the second or third slice)
and indicates the number of slices purchased.
On the graph below, the blue line connects the points associated with Jane’s
willingness to pay for each slice. We call this line the marginal benefit curve.
The red line represents the cost of each slice. We call this line the marginal
cost curve.
The intersection of these lines occurs at the point where the price of each slice of
pizza equals what Jane’s willing to pay for that slice. That is, the intersection
occurs where Jane’s marginal benefit curve intersects her marginal cost curve. Jane
consumes where her marginal benefit equals her marginal cost (i.e. where MB = MC).
The negative slope of the marginal benefit curve demonstrates what we refered to
earlier as the Law of Diminishing Marginal Utility.
The graph also illustrates the concept of consumer surplus. If Jane consumes 1
slice, then she receives $2 in net benefit. If Jane consumes two slices, she
receives $3 in overall net benefit. Jane stops purchasing pizza at the third slice,
where the net benefit is zero. By summing up her net benefit, we get an approximation
of the area below the marginal benefit curve, but above the marginal cost (price)
curve. This area is Jane's consumer surplus.
Note that although we can use marginal analysis to find an answer to the
question "how much should Jane buy", we don’t necessarily know how
much overall net benefit Jane derives from that consumption. Marginal analysis
allows one to determine how much of an activity will occur, but doesn't necessarily
tell us whether the net benefit derived from that activity will be positive
or negative.