Cost-benefit analysis (CBA)

0:00- [Instructor] So let's think a little bit about cost-benefit analysis. And this helps you make decisions. So let's start with an example. Let's say that you have 5 hours some evening and you have two different things that you can do at those 5 hours. You can study for a test or you can work.

0:20And you know that if you study 5 hours for that test, you will get an A in that class. Or let's say you somehow know that you will get 100 on that test. So you will get 100% on that test. And you know that if instead you were to go to work for those 5 hours, you will make $100.

0:39So you have to decide how do you want to spend those 5 hours. And to do that, you could think about, well, what is the cost and benefit? So let's think about these two scenarios. So we have study, and then we have work. And let's think about, I'll write the benefit right over here, benefit.

0:58And then let's think about the cost. I could make it into a little bit of a table here with some columns and some rows. So study, you get an A, get a plus on the test. I'll get to the cost in a second. The work, the benefit is you get $100. Now, so what do you think is the cost to studying to get that A?

1:25Well, you could think about it in terms of opportunity costs, which is the benefit that you would've gotten from your next best alternative. So one way to think about it is you're missing out on that $100. And similarly, what is the cost of working and getting that $100?

1:42Well, maybe not getting A on test. So we've just done a cost-benefit analysis. Which benefit matters more and which cost, I guess you could say matters less to you to pick what you're going to do. Now in this example, I just did studying for 5 hours or working for 5 hours.

2:04But in many situations you're not thinking about not studying at all or not working at all, but you're trying to figure out how much to study or how much to work. And for that, we can think about the marginal benefit and the marginal cost. So the word marginal, let me just put this in quotes before, what do you think that even means?

2:23Well, when you're formatting a document, the margin, you could have the document right over there, the margin is the things on the side or at the top. So I like to think the margin is things on the edges. And when people are thinking about marginal benefit or marginal cost, they're not thinking about the total benefit or the total cost like we just thought about here, they think about the benefit or the cost for the next increment of doing something.

2:48So instead of saying 5 total hours, you might say, what's the marginal benefit or the marginal cost for an extra minute or an extra hour of studying versus an extra hour of work. So another way you could think about is the incremental, the incremental benefit or the incremental cost.

3:06So let's say, let me make another table here that thinks of things in a marginal way. So I'll make the same table actually here, study and work. And I will say marginal benefit, marginal, I'm going into that row, marginal benefit, and marginal, marginal cost. And let me make the table here.

3:37So there, and then there, all right, the table is made. And so let's say we're thinking about the marginal benefit or that incremental benefit on an hourly basis. So let's say that gives you 20 points on test per hour, per hour. And in the real world, you don't know for sure that if you study an extra hour you'll get a 20 point improvement on your test, but let's just say for the sake of an example, you do know that.

4:07And let's say when you work, you get paid $20 an hour. And a good clue that we're talking about incremental benefit or cost or marginal benefit or cost is it's given as a rate. If you do it per hour, what's going to happen? So by the same logic, every time you decide to study an extra hour, you aren't working that extra hour.

4:28So your marginal cost is gonna be your opportunity cost of your next best alternative. In the real world we have many different alternatives this could get very complicated but for the sake of a simple example in a world where you can only do two different things your cost is $20 an hour, 'cause that's the opportunity cost of not working.

4:43And similarly if you do work that extra hour that's an opportunity cost of not studying. So you're going to lose 20 points on test per hour. That's what it's costing you, you're not going to be able to get that 20 points. So how would you think about this decision here?

5:00Well, this decision, it actually makes a big difference on what situation you are already in. If for example, you are already confident that you're going to get a 90 on your test and you have no money, especially if you have no money and you need to make some purchase and maybe a 90 is already an A, well then the marginal benefit of working probably outweighs the marginal cost.

5:27Hey, I have no money, $20 for that extra hour makes sense, and I'm already in a pretty good range on my test. Now on the other hand, if you were in a scenario where you have right now thought you were only gonna get a 20% on that test, and let's say that you won the lottery, and you have $1M, not a realistic example but we can daydream, well then you might say, "Alright, there's a lot more benefit for me, I need to get the score up in order to pass the class.

5:58I probably have to get much higher than even a 40 or 60 or an 80, I wanna get to 100 here," much more marginal benefit to study that incremental hour than maybe $20 doesn't mean that much to me now. I don't need it as badly. But this is just the beginning. Hopefully you learned a little bit more structure of how to think about cost-benefit analysis and also the word marginal.

6:19I was much older than many of y'all are before I learned this idea and now I use it all of the time.