What Is Marginal Analysis?

Marginal analysis is an examination of the additional benefits of an activity compared to the additional costs incurred by that same activity. Companies use marginal analysis as a decision-making tool to help them maximize their potential profits. Marginal refers to the focus on the cost or benefit of the next unit or individual, for example, the cost to produce one more widget or the profit earned by adding one more worker.

Understanding Marginal Analysis

Marginal analysis is also widely used in microeconomics when analyzing how a complex system is affected by marginal manipulation of its comprising variables. In this sense, marginal analysis focuses on examining the results of small changes as the effects cascade across the business as a whole.

Marginal analysis is an examination of the associated costs and potential benefits of specific business activities or financial decisions. The goal is to determine if the costs associated with the change in activity will result in a benefit that is sufficient enough to offset them. Instead of focusing on business output as a whole, the impact on the cost of producing an individual unit is most often observed as a point of comparison.

Marginal analysis can also help in the decision-making process when two potential investments exist, but there are only enough available funds for one. By analyzing the associated costs and estimated benefits, it can be determined if one option will result in higher profits than another.

Marginal Analysis and Observed Change

From a microeconomic standpoint, marginal analysis can also relate to observing the effects of small changes within the standard operating procedure or total outputs. For example, a business may attempt to increase output by 1% and analyze the positive and negative effects that occur because of the change, such as changes in overall product quality or how the change impacts the use of resources. If the results of the change are positive, the business may choose to raise production by 1% again, and reexamine the results. These small shifts and the associated changes can help a production facility determine an optimal production rate.

Marginal Analysis and Opportunity Cost

Managers should also understand the concept of opportunity cost. Suppose a manager knows that there is room in the budget to hire an additional worker. Marginal analysis tells the manager that an additional factory worker provides net marginal benefit. This does not necessarily make the hire the right decision.

Suppose the manager also knows that hiring an additional salesperson yields an even larger net marginal benefit. In this case, hiring a factory worker is the wrong decision because it is sub-optimal.

How to Perform a Marginal Analysis

Marginal analysis is as simple as taking the margin benefit of an outcome and subtracting the marginal cost. However, this analysis may be difficult to assess as there are many variables and moving parts to consider. To perform a marginal analysis, you should first understand the fixed and variable costs of an activity. Because the fixed costs are not likely to change, your marginal cost will often be equal to your variable expenses.

Next, you can begin marginal analysis by finding the marginal cost and the marginal expense of an activity. Each will simply be the change in cost or benefit for every unit consumed or acquired. Note that while one aspect may remain the same (either the benefit or the cost may be constant), one aspect will often be variable.

Consider the example of consuming pizza at $2/slice. In this example, marginal cost is easy to quantify, as every additional slice of pizza has a marginal cost equivalent to $2. On the other hand, marginal benefit may be more difficult to quantify. If you haven't eaten all day and are hungry, you may state that the first slice of pizza you eat is worth $10 to you. If this is the case, marginal analysis has led you the net benefit equal to the value of $8.

To continue performing marginal analysis, consider how both the benefit and the cost will change with each slice of pizza consumed. If each slice costs $2, your marginal cost will always be $2. However, as you eat more pizza, you'll become full. In fact, there will be a point where you may get sick and begin to have negative marginal benefit for each additional slice eaten.

Rules of Marginal Analysis

When performing marginal analysis, there are two profit maximization rules to consider. These two rules dictate the point at which companies should manufacture goods and allocate resources.

Rule #1: Operate Until Marginal Cost Equals Marginal Revenue

The overarching rule of marginal analysis is that it is usually in a company's best interest to perform an activity as long as the marginal revenue is greater than the marginal cost. When marginal revenue and marginal cost are equal, there is theoretically no financial incentive for the company to continue the activity, though there may be non-financial factors to consider.

Consider a manufacturing example where it costs $2 to make a good whose marginal revenue is $5. For this unit, the company makes $3. If the next unit costs $4 to make, the company still earns a marginal profit because marginal revenue of $5 is greater than the marginal cost. If the next unit were to cost $6 to make, it would no longer be financially feasible to make and sell the good.

The point at which marginal revenue and marginal cost intersect is often called marginal equilibrium. It is the point at which total company profit is maximized, even if unit profit is not at its highest. In more simple terms using the pizza example above, you should continue to consume pizza as long as you think the marginal benefit you receive of each slice is worth at least the $2 you're paying per piece.

Rule #2: Equalize Marginal Return Across Products

Another important rule related to marginal analysis relates to companies that have different products. If a company chooses to only dedicate resources to one product, the potential marginal revenue of the other products is foregone in favor of a product likely with a diminishing marginal profit. To avoid this, every product should have an equal marginal revenue to maximize the amount of benefit obtained, especially if there are resource constraints at play.

Consider the table below outlining the marginal return received from two products. If one unit of Product A is consumed, the consumer receives a marginal benefit of 100. If a third unit of Product B is consumed, the consumer receives a marginal benefit of 30 for that third unit.

Based on the table above, this second rule would dictate that the first unit consumed should be one unit of Product A. However, we now know the marginal return of a second unit of Product A only yields a return of 25. This second rule would call for the consumer to consume units of Product B until the marginal revenue of the two products meet. In this example, the highest return would occur after 1 unit of Product A and 3 units of Product B have been consumed.

Let's return once more to our pizza example. Instead of only consuming pizza, imagine the marginal benefit of having a refreshing drink in between bites or slices. The argument here is instead of trying to maximize your benefit received consuming one good, you should try to have the marginal benefit received from the pizza (considering its price) equal to the marginal benefit received from a drink (also considering its price).

Marginal Cost vs. Marginal Benefit

A marginal benefit (or marginal product) is an incremental increase in a consumer's benefit in using an additional unit of something. A marginal cost is an incremental increase in the expense a company incurs to produce one additional unit of something.

Marginal benefits normally decline as a consumer decides to consume more and more of a single good. For example, imagine a consumer decides that she needs a new piece of jewelry for her right hand, and she heads to the mall to purchase a ring. She spends $100 for the perfect ring, and then she spots another.

Since she has no need for two rings, she would be unwilling to spend another $100 on a second one. She might, however, be convinced to purchase that second ring at $50. Therefore, her marginal benefit reduces from $100 to $50 from the first to the second good.

If a company has captured economies of scale, the marginal costs decline as the company produces more and more of a good. For example, a company is making fancy widgets that are in high demand. Due to this demand, the company can afford machinery that reduces the average cost to produce each widget; the more they make, the cheaper they become. On average, it costs $5 to produce a single widget, but because of the new machinery, producing the 101st widget only costs $1. Therefore, the marginal cost of producing the 101st widget is $1.

Limitations of Marginal Analysis

Marginal analysis derives from the economic theory of marginalism—the idea that human actors make decisions on the margin. Underlying marginalism is another concept: the subjective theory of value. Marginalism is sometimes criticized as one of the "fuzzier" areas of economics, as much of what is proposed is hard to accurately measure, such as an individual consumers' marginal utility.

Also, marginalism relies on the assumption of (near) perfect markets, which do not exist in the practical world. Still, the core ideas of marginalism are generally accepted by most economic schools of thought and are still used by businesses and consumers to make choices and substitute goods.

Modern marginalism approaches now include the effects of psychology or those areas that now encompass behavioral economics. Reconciling neoclassic economic principles and marginalism with the evolving body of behavioral economics is one of the exciting emerging areas of contemporary economics.

Since marginalism implies subjectivity in valuation, economic actors make marginal decisions based on how valuable they are in the ex-ante sense. This means marginal decisions might later be deemed regrettable or mistaken ex-post. This can be demonstrated in a cost-benefit scenario. A company might make the decision to build a new plant because it anticipates, ex-ante, the future revenues provided by the new plant to exceed the costs of building it. If the company later discovers that the plant operates at a loss, then it mistakenly calculated the cost-benefit analysis.

That said, inaccurate calculations reflect inaccuracies in cost-benefit assumptions and measurements. Predictive marginal analysis is limited to human understanding and reason. When marginal analysis is applied reflectively, however, it can be more reliable and accurate.

Example of Marginal Analysis in Manufacturing

When a manufacturer wishes to expand its operations, either by adding new product lines or increasing the volume of goods produced from the current product line, a marginal analysis of the costs and benefits is necessary. Some of the costs to be examined include, but are not limited to, the cost of additional manufacturing equipment, any additional employees needed to support an increase in output, large facilities for manufacturing or storage of completed products, and as the cost of additional raw materials to produce the goods.

Once all of the costs are identified and estimated, these amounts are compared to the estimated increase in sales attributed to the additional production. This analysis takes the estimated increase in income and subtracts the estimated increase in costs. If the increase in income outweighs the increase in cost, the expansion may be a wise investment.

For example, consider a hat manufacturer. Each hat produced requires seventy-five cents of plastic and fabric. Your hat factory incurs $100 dollars of fixed costs per month. If you make 50 hats per month, then each hat incurs $2 of fixed costs. In this simple example, the total cost per hat, including the plastic and fabric, would be $2.75 ($2.75 = $0.75 + ($100/50)). But, if you cranked up production volume and produced 100 hats per month, then each hat would incur $1 dollar of fixed costs because fixed costs are spread out across units of output. The total cost per hat would then drop to $1.75 ($1.75 = $0.75 + ($100/100)). In this situation, increasing production volume causes marginal costs to go down.

The Bottom Line

Marginal analysis is a critical part of a business and life that dictates what level of activity to operate at. Marginal analysis discovers the point at which marginal revenue equals marginal cost. If someone operates below this point, they may not be taking advantage of business opportunities. If someone operates above this point, they may lose resources every unit. Marginal analysis drives how many units a company produces and often decides what (and how much) consumers buy.