Marginalism: Definition, How It Works, Key Insight, and Example

What Is Marginalism?

Marginalism is the economic principle that economic decisions are made and economic behavior occurs in terms of incremental units, rather than categorically. The key focus of marginalism is that asking how much, more or less, of an activity (production, consumption, buying, selling, etc.) a person or business will engage in is a more fruitful question to further economic inquiry than categorical questions. The key insight of marginalism is that people make decisions over specific units of economic goods (economists say "at the margin"), rather than in an all-or-none fashion.

Marginalism has formed one of the foundational principles of economic theory and research since its adoption in the 1870s, known as the Marginal Revolution. Concepts that originate from the principle of marginalism include marginal utility; marginal costs and benefits; marginal rates of substitution and transformation; and marginal propensities to consume, save, or invest. These are all core ideas of modern micro- and macroeconomics, and marginal thinking, in general, is widely regarded by economists as an important component of what it means to be an economist.

Key Takeaways

  • Marginalism is the insight that people make economic decisions over specific units or increments of units, rather than making categorical, all-or-nothing decisions.
  • Marginalism began with the Marginal Revolution in economics in the 1870s and quickly came to form a foundational aspect of economic thinking.
  • Marginalism gained influence in economics because of its vast explanatory power in economic decisions and human behavior in general.

Understanding Marginalism

The idea of marginalism was separately developed by three European economists, Carl Menger, William Stanely Jevons, and Leon Walras, in the 19th century. It resolves the Diamond-Water Paradox that was described by Adam Smith. The Diamond-Water Paradox asserts that because diamonds, which at the time had little practical use value, command a far higher market price than water, which has many uses and is necessary for human survival, then use value must not be the deciding factor in the values and market prices of economic goods. Smith used this argument to support his labor theory of value and oppose previous ideas that use value was more important.

The marginalists argued that Smith had gotten it wrong in a fundamental way. The values that people place on economic goods and the prices they set for them are not a matter considering broad categories of goods such as all water or all diamonds considered together—in terms of either their use value or their labor cost. Rather, they are based on the specific uses that people have for each individual unit of a good. People will naturally put the first unit of a good they are able to obtain to their most highly valued use, and use subsequent marginal units for less and less valued ends. This is known as the concept of diminishing marginal utility.

Because the use value of each additional marginal unit of good decreases, the prices of goods that are more plentiful relative to the uses people have for them will be lower, and the prices that people are willing to pay for goods that are more scarce will be higher. This explains why diamonds (usually) command a higher market price than water; people value diamonds and water for their marginal use value and diamonds are rare relative to their usefulness, while water literally falls out of the sky and springs up out of the earth for free.

Thus, an average human being is willing to pay more for an additional diamond than an additional glass of water. In places where usable water is scarce, such as deserts or a ship adrift at sea, the reverse may be true, and people will gladly trade all the diamonds they may have in return for a single cup of water to drink in order to survive.

This concept of marginal utility was then used to derive the laws of supply and demand as we know them, and its application to all areas of economics swept the profession, replacing the labor theory of value and other older ideas. Because economics is essentially the science of how people use and value economic goods in order to achieve their limitless wants and needs with limited and scarce resources at hand, marginal thinking is ubiquitous in all areas of economics.

Marginalism in Action

Marginalism is not just a theoretical idea, but can be seen across all sorts of real-world human action. Indeed, this is why the insight of marginalism is so powerful and became so important to economists.

For example, if you sit down for breakfast to eat a plate of eggs and bacon you are making a decision at the margin. On an average day, you might eat two eggs and three strips of bacon to meet your basic nutritional needs, or you might eat a third egg if you have some strenuous physical activity or work planned for the day.

In either case, you decide in terms of how many eggs to eat based on the use value you place on each egg; in no case do you decide between whether to eat all the eggs that exist in the universe or else zero eggs. You are making a marginal decision rather than a categorical decision, so marginal analysis can be applied to understanding how you decide and help you find a solution that will best fit your needs.

Making decisions at the margin comes naturally and often supports better decisions.

Another familiar example of marginalism comes from behavioral change. People who wish to change a habit or behavior, good or bad, often find it helpful to frame the question marginally, rather than as an all-or-nothing decision. For example, a person wishing to reduce a bad habit, such as problem drinking, may focus on not drinking for one additional day, rather than on a one-time, life-changing decision.

Alternatively, a person who is looking to improve their physical fitness might approach it by counting their steps and increasing their number of steps each day, rather than focus on a seemingly overwhelming goal such as losing 300 pounds all at once.