Small things often matter the most when it comes to the success or failure of a business. Making the right decision at the right time is about resource allocation, cost cuts, focused investments, and expansion. These can make or break a business. Marginal Analysis is an Analytical tool that allows you to make better decisions by comparing costs and benefits at a microscopic level. Before we dive deep into the nuances of marginal analysis as an economic tool and some marginal analysis examples, let us quickly gather a high level of knowledge.
What is Marginal Analysis? (Definition & Explanation)
Marginal analysis is the comparison between the additional benefits of producing or consuming one additional unit and the cost of producing or consuming the same unit.
In simpler terms, Marginal analysis is a way of looking at the benefits and costs of doing a little bit more or a little bit less of something. You can make better decisions by comparing the costs and benefits of producing or consuming that extra bit. An example of marginal analysis will help you wrap your head around the concept.
Marginal Analysis Real Life Example
Let’s say a restaurant wants to apply marginal analysis to determine the ideal number of tables in its dining room for maximum profit. The first step in marginal analysis would be to conduct marginal cost analysis, that is, determining the cost of setting up a new table in this case. Then, it’s time for marginal benefit analysis, that is, the observation of revenue drawn by the additional table in this case.
Suppose setting up a new table costs $150; that’s the marginal cost. If the new table brings $20 in profits per hour, it would bring $160 by the end of the day (assuming the restaurant operates for 8 hours a day). So, $160 is the marginal benefit for the day. Now, if the marginal benefit is greater than the marginal cost, which it is in this case, it makes sense to add another table. This is how marginal decision-making works.
Does it mean that it will always be profitable to add an extra table? Not really, if you keep adding units, the marginal benefit tends to decrease. Alfred Marshall defined this as the law of diminishing marginal utility. Yes, there’s a good deal more to learn about marginal utility analysis.
Marginal Analysis Concept and Origin
Marginal analysis is a concept discussed and upheld by scores of economists since the nineteenth century. If we try to find the origin of the concept of marginal analysis, the name of Antoine Augustin Cournot will pop up. This French Philosopher was the first one in recent history to ‘define and draw a demand curve to illustrate the relationship between price and demand for a given item.’
A little while later came British economist Alfred Marshall, who helped shape the concept of marginalism, defined the law of marginal utility, and built the foundation for marginal analysis in economics as we understand it today.
Marshal explained that ‘The additional benefit which a person derives from a given increase in the stock of a thing diminishes with every increase in the stock that he already has.’ This is the law of diminishing marginal utility. This is what makes it so important to find the optimal number of units to produce or consume for maximum profitability – it’s not a make more, earn more situation.
Marginal Analysis Formula with Example
The formula of marginal analysis usually depends on the type of units being analyzed. Nevertheless, if you want a general formula for marginal analysis, it can be expressed as follows.
Basic Formulas:
- Marginal Cost (MC) = Change in Total Cost / Change in Quantity
- Marginal Benefit (MB) = Change in Total Benefit / Change in Quantity
If that doesn’t make a lot of sense, let’s understand the formula with an example. Let’s say a company sells 500 bicycles worth $100 each per year. The production cost of a bicycle is $30, including materials and wages, and they invest $25000 in marketing. The math suggests that they make a profit of $10,000 per year.
The company is considering a new marketing campaign, which, they predict, will lead to the sale of 1000 bicycles. However, this new marketing campaign will cost them $50,000. Now, it falls upon marginal cost and benefit analysis to determine whether the company should make the move. Let’s apply the formula to this situation and see what happens.
The total making cost of 1000 bicycles is $30,000, and if the marketing campaign costs $50,000, the company is left with $20,000.
Marginal benefit = $100,000-$50,000/1000-500
That is $100 per unit.
Marginal cost = $80,000 – $40,000/1000-500
That is $80 per unit.
That means the marginal benefit is greater than the marginal cost by $20. Hence, it makes sense for the business to invest in the new marketing campaign. This is how marginal analysis in decision-making works.
What is a Marginal Analysis Graph?
The marginal cost-benefit analysis graph represents the relationship between the additional cost of production and the quantity of the product. The X-axis shows the quantity produced, and the Y-axis represents the marginal cost.
The marginal cost analysis graph is upward sloping because as you increase the quantity of the product, additional resources like labourers, raw material, and new machines are required. The point at which the marginal cost curve intersects the average cost line represents the optimal quantity.
Situations in Which Marginal Analysis Doesn’t Work
Marginal analysis is a powerful tool for decision-making, but it is not a foolproof formula for every situation. For the following situations, marginal analysis is the least beneficial
- Significant fixed costs: It is important for marginal analysis to work that the costs and benefits change in small increments. Hence, it doesn’t work well when there are high fixed costs. For instance, if a business wants to set up a factory, the cost doesn’t change in small increments. It becomes difficult to apply marginal analysis in such a case.
- Non-linear relationship between cost and benefits: Let’s say a company wants to increase sales by offering discounts; there has to be a point where increased discounts do not lead to a proportional increase in sales and/or profits.
- Marginal analysis doesn’t consider externalities: Marginal analysis takes into account the cost and benefit of producing extra units or setting up a factory, but it fails to factor in external costs like the cost of the pollution caused by the factory.
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