Marginal Analysis Definition
Marginal analysis refers to a technique of comparing the additional benefit and costs produced by an activity. The analysis result discloses whether the activity, change, or new addition is favorable to the business.
It is common in decision-making and aligns with maximizing satisfaction, income, or profit. Decision-making processes favor profit maximization by equating marginal revenue and marginal cost. For example, organizations use it to make decisions on strategic investments, such as for analyzing and choosing early-stage manufacturing technology projects.
Table of contents
- Marginal analysis in microeconomics and business is a method involving the evaluation of the additional benefit and cost that an activity generates.
- The analysis’s findings show whether an activity, development or new addition is advantageous to the company’s operations.
- Businesses use it in decision-making to determine profitability and design input and operations.
- Every change or additional cost doesn’t need to derive a proportional benefit; therefore, the analysis is flawed and has limitations.
Marginal Analysis Explained
Marginal analysis is an essential concept in microeconomics. It involves the evaluation of additional costs and benefits associated with the introduction of a new activity. It is helpful in the decision-making process of business expansions and regulating the production scale. Furthermore, it can explain why specific necessities are cheap for households, but at the same time, luxury items are expensive.
It is not always necessary that every marginal change results in benefit, which is why the analysis is essential to organizations. There are different types of decisions for which the analysis considering items like marginal cost and opportunity cost comes into aid, like the make or purchase, capital expenditure, expansion, contraction, advertising, hiring, and product line decisions. The analysis provides a projected result based on which management makes business decisions.
The primary motive of any business or company is to make a profit, and marginal analysis is an essential technique in identifying potential profit from a slight change in operations. Two rules are associated with the analysis process focusing on profit maximization, the equilibrium rule, and the efficient allocation rule. Equilibrium rule focus on the equilibrium of the marginal revenue and marginal cost. The efficient allocation rule following the efficiency principle focuses on producing the same marginal return for each unit of effort.
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Let’s look into some examples for a better understanding:
John owns a burger shop. It is a well-established joint and has earned goodwill among people. He is lately thinking of expanding the production scale. The shop sells 10,000 burgers in a month. The total fixed cost per month is $10,000, and the expense incurred for a burger is $2. If the number of burgers sold in a month is 10,000 and the total fixed cost per month is $10,000, then the fixed cost per burger is $1 ($10,000/10,000). Hence the total cost per burger is $3 ($2+$1).
John plans to increase the output so that the number of burgers sold in a month will be 10,500. John’s decision to increase the output using the existing facilities led to applying a marginal analysis. As a result, the new fixed cost per burger will be $0.952 ($10,000/$10,500), and the new total cost per burger will be $2.952 ($2+$0.952). In this case, the fixed cost per burger and the total cost per burger decreased. Hence, increasing production will help John lower costs in this hypothetical marginal analysis example.
A baking company is planning to increase the sales of its baked goods. As a result, they want to hire five new bakers. Before hiring, they run a marginal analysis to compare the additional benefit and costs incurred. The analysis indicates that hiring bakers is beneficial because the income increase outweighs the cost.
Marginal Analysis Uses
- It gives a data point for making better and rightful business operations decisions and strategies. Corporate teams, analysts, and other management professionals commonly use analysis to understand the pros and cons of any project before making any decisions. Furthermore, without the proper marginal analysis, a company can make loss-making decisions that are not fruitful for the organization.
- It helps in understanding the cost to be spent and the benefit to gain from the activity.
- It helps to understand the maximum potential and, in some cases, the potential loss from the unit change in the activity.
- Often, the analysis helps determine the opportunity cost associated with a change in the business activity.
- The analysis observes if the unit change may bring short-term or long-term benefits for the company.
Marginal Analysis Limitations
- Marginal analysis in economics is based on projected results, which means the result and whole activity target are based on a benchmark rather than the actual output. Therefore, the data and information offered by the assessment are hypothetical and inaccurate.
- If the assessment is not conducted correctly, any error can induce an unnecessary loss to the company in terms of cost. Furthermore, the assumptions in the analysis should be taken carefully. Otherwise, the whole test becomes a failure and useless to the company.
Frequently Asked Questions (FAQs)
Its application is essential because it helps in the following:
– Business decision-making process such as decisions regarding expansions and new project design.
– It helps equate or compare the factors of benefits with the expenses.
– It helps contribute to profit optimization planning.
The two critical rules are:
– Equilibrium rule: Stating that marginal cost should be equal to the marginal revenue.
– Efficient allocation rule: Focus on producing the output at the lowest possible cost, eliminating all the unnecessary expenses and effort from the production process.
It involves the calculation of net benefit. The net benefit is the difference between the total benefit and total cost or marginal benefit and marginal cost.
Net benefit = Marginal benefit – Marginal cost
Marginal benefit and cost are calculated using the following formula:
Marginal benefit = Change in total benefit/change in quantity
Marginal cost = Change in total cost/Change in quantity produced
This article has been a guide to Marginal Analysis and its definition. Here, we explain it in detail, including its examples, uses, and limitations. You can learn more about it from the following articles –