By the end of this section, you will be able to: Show
“Economics is the painful elaboration of the obvious” – Anonymous. That quote might seem quite relevant when the biggest conclusion of our last section was that you should do something if the benefits outweigh the costs. While sometimes economics can seem obvious, it is important to first understand how a rational consumer should behave before seeing how we fail to meet that standard. Marginal AnalysisIn the last section we showed how to make a binary decision, but not all decisions fit that category. Many are ‘how much’ decisions. For example, if you have decided to go clubbing, how many drinks do you buy? This is a decision where we use marginal analysis. Marginal analysis is the process of breaking down a decision into a series of ‘yes or no’ decisions. More formally, it is an examination of the additional benefits of an activity compared to the additional costs incurred by that same activity. To make a decision using marginal analysis, we need to know the willingness to pay for each level of the activity. As mentioned, this is also known as the marginal benefit from an action. To decide how many drinks to buy, you have to make a series of yes or no decisions on whether to buy an additional drink. In Table 1.3a the marginal benefit is diminishing. This means that you are willing to pay more for the 1st drink than the next. Your friends are all drinking, so you are likely willing to pay quite a lot for your 1st drink. By the 4th, you may feel as though you do not need another. So how many drinks will you buy if the cost is $7? To make this decision, we must use marginal analysis for each level. This means comparing our marginal benefit with marginal cost of an additional unit of activity. In this case marginal cost is just equal to $7.  For the 1st Drink: MB = $20 > MC = $ 7, you should buy the drink. For the 2nd Drink: MB = $12 > MC = $ 7, you should buy the drink. For the 3rd Drink: MB = $6 < MC = $ 7, you should not buy the drink. With this simple process we can easily see that you will buy 2 drinks, unless there is a price change. Net BenefitWhat is our net benefit from the actions, or how much ‘happiness’ have we gained? To calculate, all we have to do is add up our benefits and subtract our costs. Total Benefit = $20 + $12 = $32 Total Cost = $7 + $7 = $14 Net Benefit = $32 – $14 = $18 It is important to recognize that our act of marginal analysis has maximized this benefit. Consider what would happen if we purchased 3 drinks. Total Benefit = $20 + $12 + $6 = $38 Total Cost = $7 + $7 + $7 = $21 Net Benefit = $38 – $21 = $17 Note that although total benefit is more than it was previously, net benefit is lower. Looking closer we can see that net benefit fell because our total costs rose ($14 –> $21) by more than our total benefits ($32 –> $38). As a quick rule:
This is why we look at the marginal net benefit of a decision, rather that the total. It is as though all the previous actions are ‘sunk’. We can calculate the marginal net benefit of a decision by subtracting marginal cost from marginal benefit. Marginal net benefit of the first drink is $13 ($20 – $7), the 2nd is $5 ($12 – $7), and the third is -$1 ($6 – $7). As long as the marginal net benefit is positive, we should increase our activity! SummaryMarginal analysis is an essential concept for everything we learn in economics, because it lies at the core of why we make decisions. We have just scratched the surface of it now, but will go more in depth in Topic 3. For now, we will turn our attention to a slightly different topic – trade.
Marginal Analysis The examination of the additional benefits of an activity compared to the additional costs incurred by that same activity Marginal Benefit The additional satisfaction one gains from an additional unit of an activityMarginal Cost The additional costs from an additional unit of an activity Marginal Net Benefit The difference between the marginal benefits and marginal costs of an action
Understanding Marginal AnalysisIn microeconomics, most decisions usually evaluate whether the benefit of a particular activity or action is greater than the cost. Marginal analysis comes in handy when making a decision with a causal relationship involving two variables. It explains the potential effect of some conditional changes on a company as a whole. By examining the associated costs and potential benefits, marginal analysis provides useful information that is likely to prompt price or production change decisions. Marginal analysis also looks at the conditions under which the company may continue with the same cost of producing an individual unit or output in the face of expected or actual changes. Here, the dominating principle is the adjustment to change. The idea is that it is worthwhile for a company to continue investing until the marginal revenue from each extra unit is equal to the marginal cost of producing it. Marginal analysis may also be applied in a situation where an investor is faced with two potential investments but with the resources to only invest in one. The investor can use marginal analysis to compare the costs and the benefits of both investments to determine the option with the highest income potential. Uses of Marginal AnalysisThe following are the two prevalent uses of marginal analysis: 1. Observed changesMarginal analysis can be used by managers to create controlled experiments based on the observed changes of particular variables. For example, the tool can be used to evaluate the impact of increasing production at a given percentage on cost and revenues. A benefit is accrued when the marginal cost is reduced or the increased revenues cover and spill over total production costs. If the experiment yields a positive result, incremental steps are taken until the result yields a negative outcome. This may be the scenario when the market cannot take the additional production units, leading to excessive overheads. At that stage, a company with the capacity to expand will opt to increase its market reach. 2. The opportunity cost of an actionManagers regularly find themselves in situations where they are required to make a choice among available options. For example, suppose a company has a single job opening, and they have the choice of hiring a junior administrator or a marketing manager. Marginal analysis may indicate that the company has resources to grow and that the market is saturated. As a result, hiring a marketing manager will yield higher returns than an administrator. Rules of Marginal Analysis in Decision-MakingThere are two rules for profit maximization that make marginal analysis a key component in the microeconomic analysis of decisions. They are: 1. Equilibrium RuleThe first rule posits that the activity must be carried out until its marginal cost is equal to its marginal revenue. The marginal profit at such a point is zero. Typically, profit can be increased by expanding the activity if the marginal revenue exceeds marginal cost. Marginal benefit is a measure of how the value of cost changes from the consumer side of the equation, while the marginal cost is a measure of how the value of cost changes from the producer side of the equation. The equilibrium rule implies that units will be purchased up to the point of equilibrium, where the marginal revenue of a unit is equal to the marginal cost of that unit. 2. Efficient Allocation RuleThe second rule of profit maximization using marginal analysis states that an activity should be performed until it yields the same marginal return for every unit of effort. The rule is premised on the idea that a company producing multiple products should allocate a factor between two production activities such that each provides an equal marginal profit per unit. If it is not achieved, profit could be realized by allocating more input to the activity with the highest marginal profit and less to the other activity. Limitations of Marginal AnalysisOne of the criticisms against marginal analysis is that marginal data, by its nature, is usually hypothetical and cannot provide the true picture of marginal cost and output when making a decision and substituting goods. It therefore sometimes falls short of making the best decision, given that most decisions are made based on average data. Another limitation of marginal analysis is that economic actors make decisions based on projected results rather than actual results. If the projected income is not realized as predicted, the marginal analysis will prove to be worthless. For example, a company may decide to start a new production line based on a marginal analysis projection that the revenue will exceed costs to establish the production line. If the new production line does not meet the expected marginal costs and operates at a loss, it means that the marginal analysis used the wrong assumptions. Special ConsiderationsMarginal analysis may also apply to the effects of small changes and the opportunity cost concept. In the former, marginal analysis relates to observed changes with total outputs. Evaluating such changes can help determine the standard production rate. It is common in employment scenarios, where the Human Resource (HR) manager makes a hiring decision. Suppose a company’s budget allows the recruitment of one employee. With marginal analysis, the HR can know whether an additional employee in the production department provides net marginal benefit. Additional ResourcesCFI is the official provider of the global Capital Markets & Securities Analyst (CMSA)® certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:
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The main advantage that marginal analysis has over most other popular pricing methods is that it
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