Average vs Marginal: The most common mistake in economics

Something I have noticed over time is that there is always a mass of confusion surrounding average vs marginal costs (or benefits) in economics.

Although there is some confusion with fixed vs variable costs as well (an issue that I believe is closely related) the issue of average vs marginal costs appears ohh so often.

Greg Mankiw mentions a case from the paper recently here.  I remember a case where it was important that was blogged about here.

Now, the difference is important as it is “marginal” costs and benefits that determine decisions (implicitly) not average costs and benefits.  However, if people are often confused between the two is it not possible that many people do make decisions based on the average?  There are a lot of interesting questions implicit here – something we should discuss over the next week ;) – eg do people choose marginal when describing average?  does this confusion serve some “evolutionary” purpose?

  • HH

    I’m pretty sure that when it comes to ourselves, we always make decisions based on marginal value. Whether to have another slice of pizza or to buy another family car, I doubt anyone takes into account the average benefits of those items. Instead, we obviously focus the marginal benefit of the next one.
    I think at worst, we use the average benefit to inform our estimate of the marginal benefit of the next, but I doubt anyone ever confuses the two.

  • http://www.tvhe.co.nz Matt Nolan

    Hi HH,

    I think we subconsciously work on the marginal – but I think when in comes to conscious decisions people often mix up marginal and averages.

    There has to be some literature that looks at how people frame issues regarding “average” and “marginal” and how that influences decisions.

    An example where people often use average when they should be talking about marginal is firm pricing. Often firms will talk about an arbitrary markup on “average costs” for their pricing behaviour – something that is very different to setting prices at the margin.

    The beauty of economics stems from “thinking at the margin” – however, when people are making conscious decisions they don’t (or at least don’t say they are) always do it in this way.

  • HH

    Hi
    I agree, I think a lot of marginal “thinking” in individuals is not conscious but rather instinctive.
    I also agree that with firms you usually get a lot of references to average cost, rather than marginal. I happen to think that much of that is simply because average costs are far more easily calculable than marginal costs. I seriously doubt Ford can reliable calculate the cost of the next car, though they can probably figure out average costs over a given period and figure it out from there.
    In general, I’m more inclined to think that people and firms “talk” in terms of average costs but they generally act in terms of marginal terms.

  • http://www.tvhe.co.nz Matt Nolan

    “In general, I’m more inclined to think that people and firms “talk” in terms of average costs but they generally act in terms of marginal terms.”

    Very true – that is very much how I feel as well :)

    There are some very interesting thought exercises stemming from this way of viewing things – hopefully they will come to me and I can post on them :P

  • http://antidismal.blogspot.com/ Paul Walker

    Matt, another problem people have with costs is the difference between fixed and sunk costs and the fact that sunk costs don’t matter.

  • http://www.tvhe.co.nz Matt Nolan

    “Matt, another problem people have with costs is the difference between fixed and sunk costs and the fact that sunk costs don’t matter.”

    Very very much – its like you almost read my mind with that one (as I was planning to write about it soon) :)

  • Ashdfasfh

    dude.. why don’t u fuckin explain the difference istead of complaining about people not knowig it ..