What is a marginal analysis example?

Understanding Marginal Analysis

In 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 Analysis 

The following are the two prevalent uses of marginal analysis:

1. Observed changes

Marginal 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 action

Managers 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-Making

There are two rules for profit maximization that make marginal analysis a key component in the microeconomic analysis of decisions. They are:

1. Equilibrium Rule

The 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 Rule

The 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 Analysis

One 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 Considerations

Marginal 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 Resources

CFI 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:

• Marginal Profit
• Marginal Cost Formula
• Profit Margin
• Economics of Production

Learning Objectives

• Explain the importance of marginal analysis in economics
• Give examples of marginal cost and marginal benefit

The budget constraint framework helps to illustrate that most choices in the real world are not about getting all of one thing or all of another—we rarely decide “all burgers” or “all bus tickets.” Options usually fall somewhere on a continuum, and the choice usually involves marginal decision-making and marginal analysis.

Marginal decision-making means considering a little more or a little less than what we already have. We decide by using marginal analysis, which means comparing the costs and benefits of a little more or a little less.

It’s natural for people to compare costs and benefits, but often we look at total costs and total benefits, when the best choice requires comparing how costs and benefits change from one option to another. In short, you might think of marginal analysis as “change analysis.” Marginal analysis is used throughout economics. This subtle concept is easier to grasp with examples.

Marginal Cost

Figure 1. Charm Bracelet. What is the marginal cost of getting more silver heart charms? Should you buy just one charm for $4, or all of them for $12?

Generally speaking, marginal cost is the difference (or change) in cost of a different choice. From a consumer’s point of view, marginal cost is the additional cost of one more item purchased. From a business’s point of view, marginal cost is the additional cost of one more item produced.

Suppose you typically spend a week at the beach for vacation, but this year you earned an annual bonus from your job. Should you rent a beach house for one week or two? A one-week rental costs $2,000. A two-week rental costs $3,600. Holding everything else constant, which option is better? If you stay for two weeks, the cost is significantly higher: $3,600 versus $2,000. But consider the cost by week. The first week costs $2,000. The difference in cost between one week and two is $3,600 – $2,000, or $1,600. Thus, while the marginal cost of the first week’s rental is $2,000, the marginal cost of the second week’s rental is $1,600. This illustrates the key rule of marginal analysis: Marginal cost = the change in total cost from one option to another.

Consider another example. Imagine that you’re out getting ice cream with your friends or family. You can choose whether to buy one, two, or three scoops of ice cream. One scoop costs $3.00, two scoops cost $5.00, and three scoops cost $7.00. This information is shown in the following table.

What is the marginal cost of each scoop of ice cream? The marginal cost of the first scoop of ice cream is $3.00 because you have to pay $3.00 more to get one scoop of ice cream than you do to get zero scoops of ice cream. The marginal cost of the second scoop of ice cream is $2.00 because you only need to pay two more dollars to get two scoops than you need to pay to get one scoop. The marginal cost of the third scoop is also $2.00 because you would need to pay an additional two dollars to get that third scoop.

Marginal costs sometimes go up and sometimes go down, but to get the clearest view of your options, you should always try to make decisions based on marginal costs, rather than total costs.

This next question allow you to get as much practice as you need, as you can click the link at the top of the question (“Try another version of this question”) to get a new question. Practice until you feel comfortable doing the question and then move on.

Marginal Benefit

Generally speaking, marginal benefit is the difference (or change) in what you receive from a different choice. From a consumer’s point of view, marginal benefit is the additional satisfaction of one more item purchased. From a business’ point of view, marginal benefit is the additional revenues received from selling one more item.

Suppose you’re considering membership at the local recreation center. The basic membership gives access to the swimming pool, while the full membership gives access to the swimming pool and the weight room. What is the difference between the two memberships? Since both give access to the pool, the marginal benefit of full membership is access to the weight room.

The amount of benefit a person receives from a particular good or service is subjective; one person may get more satisfaction or happiness from a particular good or service than another. For example, you might enjoy ice cream more than your friend who is allergic to dairy. The amount of benefit you get can also change. For example, you might enjoy the ice cream more on a hot day than on a cold day. This doesn’t make it any less real, however.

Economic Rationality Revisited

How, then, do you decide on a choice? The answer is that you compare, to the best of your ability, the marginal benefits with the marginal costs. An economically rational decision is one in which the marginal benefits of a choice are greater than the marginal costs of the choice.

If we return to the recreation center example above, suppose that the basic membership is $30 per month, while the full membership is $40 per month. An economically rational decision-maker would ask, Is the marginal benefit (access to the weight room) worth the marginal cost (an extra $10 per month)? For some people, the answer will be yes. For others, it will be no. Either way, marginal analysis is an important part of economic rationality and good decision-making.

These next questions allow you to get as much practice as you need, as you can click the link at the top of the first question (“Try another version of this question”) to get a new set of questions. Practice until you feel comfortable doing the questions and then move on.

marginal analysis: examination of decisions on the margin, meaning comparing costs of a little more or a little less marginal benefit: the difference (or change) in what you receive from a different choice marginal cost:  the difference (or change) in cost of a different choice

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