What Is Marginal Analysis?
Marginal analysis is an examination of the additional benefits of an activity compared to the additional costs incurred by that same activity. Companies use marginal analysis as a decision-making tool to help them maximize their potential profits. Marginal refers to the focus on the cost or benefit of the next unit or individual, for example, the cost to produce one more widget or the profit earned by adding one more worker.
How Marginal Analysis Works
Marginal analysis is also widely used in microeconomics when analyzing how a complex system is affected by marginal manipulation of its comprising variables. In this sense, marginal analysis focuses on examining the results of small changes as the effects cascade across the business as a whole.
Marginal analysis is an examination of the associated costs and potential benefits of specific business activities or financial decisions. The goal is to determine if the costs associated with the change in activity will result in a benefit that is sufficient enough to offset them. Instead of focusing on business output as a whole, the impact on the cost of producing an individual unit is most often observed as a point of comparison.
Marginal analysis can also help in the decision-making process when two potential investments exist, but there are only enough available funds for one. By analyzing the associated costs and estimated benefits, it can be determined if one option will result in higher profits than another.
Marginal Analysis and Observed Change
From a microeconomic standpoint, marginal analysis can also relate to observing the effects of small changes within the standard operating procedure or total outputs. For example, a business may attempt to increase output by 1% and analyze the positive and negative effects that occur because of the change, such as changes in overall product quality or how the change impacts the use of resources. If the results of the change are positive, the business may choose to raise production by 1% again, and reexamine the results. These small shifts and the associated changes can help a production facility determine an optimal production rate.
Marginal Analysis and Opportunity Cost
Managers should also understand the concept of opportunity cost. Suppose a manager knows that there is room in the budget to hire an additional worker. Marginal analysis tells the manager that an additional factory worker provides net marginal benefit. This does not necessarily make the hire the right decision.
Suppose the manager also knows that hiring an additional salesperson yields an even larger net marginal benefit. In this case, hiring a factory worker is the wrong decision because it is sub-optimal.
[Important: Because marginal analysis is only interested in the effect of the very next instance, it pays little attention to fixed start-up costs. Including those costs in a marginal analysis is incorrect and produces the so-called 'sunk cost fallacy'.]
- Marginal analysis is an examination of the additional benefits of an activity compared to the additional costs incurred by that same activity. Marginal refers to the focus on the cost or benefit of the next unit or individual, for example, the cost to produce one more widget or the profit earned by adding one more worker.
- Companies use marginal analysis as a decision-making tool to help them maximize their potential profits.
- When a manufacturer wishes to expand its operations, either by adding new product lines or increasing the volume of goods produced from the current product line, a marginal analysis of the costs and benefits is necessary.
Example of Marginal Analysis in the Manufacturing Field
When a manufacturer wishes to expand its operations, either by adding new product lines or increasing the volume of goods produced from the current product line, a marginal analysis of the costs and benefits is necessary. Some of the costs to be examined include, but are not limited to, the cost of additional manufacturing equipment, any additional employees needed to support an increase in output, large facilities for manufacturing or storage of completed products, and as the cost of additional raw materials to produce the goods.
Once all of the costs are identified and estimated, these amounts are compared to the estimated increase in sales attributed to the additional production. This analysis takes the estimated increase in income and subtracts the estimated increase in costs. If the increase in income outweighs the increase in cost, the expansion may be a wise investment.
For example, consider a hat manufacturer. Each hat produced requires seventy-five cents of plastic and fabric. Your hat factory incurs $100 dollars of fixed costs per month. If you make 50 hats per month, then each hat incurs $2 of fixed costs. In this simple example, the total cost per hat, including the plastic and fabric, would be $2.75 ($2.75 = $0.75 + ($100/50)). But, if you cranked up production volume and produced 100 hats per month, then each hat would incur $1 dollar of fixed costs because fixed costs are spread out across units of output. The total cost per hat would then drop to $1.75 ($1.75 = $0.75 + ($100/100)). In this situation, increasing production volume causes marginal costs to go down.
Marginal Cost Versus Marginal Benefit
A marginal benefit (or marginal product) is an incremental increase in a consumer's benefit in using an additional unit of something. A marginal cost is an incremental increase in the expense a company incurs to produce one additional unit of something.
Marginal benefits normally decline as a consumer decides to consume more and more of a single good. For example, imagine a consumer decides that she needs a new piece of jewelry for her right hand, and she heads to the mall to purchase a ring. She spends $100 for the perfect ring, and then she spots another. Since she has no need for two rings, she would be unwilling to spend another $100 on a second one. She might, however, be convinced to purchase that second ring at $50. Therefore, her marginal benefit reduces from $100 to $50 from the first to the second good.
If a company has captured economies of scale, the marginal costs decline as the company produces more and more of a good. For example, a company is making fancy widgets that are in high demand. Due to this demand, the company can afford machinery that reduces the average cost to produce each widget; the more they make, the cheaper they become. On average, it costs $5 to produce a single widget, but because of the new machinery, producing the 101st widget only costs $1. Therefore, the marginal cost of producing the 101st widget is $1.
Limitations of Marginal Analysis
Marginal analysis derives from the economic theory of marginalism—the idea that human actors make decisions on the margin. Underlying marginalism is another concept: the subjective theory of value. Marginalism is sometimes criticized as one of the "fuzzier" areas of economics, as much of what is proposed is hard to accurately measure, such as an individual consumers' marginal utility.
Also, marginalism relies on the assumption of (near) perfect markets, which do not exist in the practical world. Still, the core ideas of marginalism are generally accepted by most economic schools of thought and are still used by businesses and consumers to make choices and substitute goods.
Modern marginalism approaches now include the effects of psychology or those areas that now encompass behavioral economics. Reconciling neoclassic economic principles and marginalism with the evolving body of behavioral economics is one of the exciting emerging areas of contemporary economics.
Since marginalism implies subjectivity in valuation, economic actors make marginal decisions based on how valuable they are in the ex-ante sense. This means marginal decisions might later be deemed regrettable or mistaken ex-post. This can be demonstrated in a cost-benefit scenario. A company might make the decision to build a new plant because it anticipates, ex-ante, the future revenues provided by the new plant to exceed the costs of building it. If the company later discovers that the plant operates at a loss, then it mistakenly calculated the cost-benefit analysis.
That said, inaccurate calculations reflect inaccuracies in cost-benefit assumptions and measurements. Predictive marginal analysis is limited to human understanding and reason. When marginal analysis is applied reflectively, however, it can be more reliable and accurate.
[Fast Fact: Economic models tell us that optimal output is where marginal benefit is equal to marginal cost, any other cost is irrelevant.]