Marginal analysis is an examination of the additional benefits of an activity compared to the additional costs incurred by the same activity. In economics, it’s used to assess the incremental impact of different decisions. Companies use marginal analysis as a decision-making tool to help them maximize their potential profits.
The basic formula for marginal analysis is:
Let’s break it down:
- Marginal Benefit (MB): This is the additional satisfaction or utility that a person receives from consuming an additional unit of a good or service. In other words, it’s the benefit gained from producing one more unit of a product or service.
- Marginal Cost (MC): This is the cost added by producing one additional unit of a product or service. It’s derived from the change in costs divided by the change in quantity.
For decision making, as long as the marginal benefit of an activity exceeds the marginal cost, it’s generally a good idea to continue that activity. Once the marginal cost exceeds the marginal benefit, it’s time to stop.
In the business world, companies use marginal analysis to evaluate whether to increase or decrease production levels, or to set prices for products and services. In essence, the concept of marginal analysis is built upon the law of diminishing returns, which states that the benefit or enjoyment derived from consuming an additional unit of a good or service tends to decrease as consumption increases beyond a certain point.
Example of Marginal Analysis
Let’s consider “Cycles Inc.”, the bicycle manufacturing company.
Currently, Cycles Inc. produces 1,000 bicycles per month, and each bicycle costs $300 to produce (including both fixed and variable costs). So, the total cost of production is $300,000.
The company is considering increasing production to 1,001 bicycles per month. The cost of producing one additional bicycle (the marginal cost) is $275. This cost is lower than the average cost because some costs are fixed and won’t increase with the production of one more bike.
If the company can sell the additional bicycle for $500, then the benefit of producing one more bicycle (the marginal benefit) is $500.
Here, the Marginal Benefit of $500 (the revenue from selling the extra bicycle) is greater than the Marginal Cost of $275 (the cost to produce the extra bicycle). Therefore, according to marginal analysis, it makes sense for the company to produce the additional bicycle.
It’s important to note that marginal costs can change. For instance, if producing more bicycles means the company has to pay overtime, the marginal cost could increase. Similarly, the marginal benefit could decrease if the company has to lower the price to sell more bicycles. This is why ongoing analysis is crucial to sound decision-making.