Marginal analysis

Marginal analysis is an analytical method developed in which the impact of small economic changes is evaluated. Marginal analysis includes discussion of marginal utility, contribution margin, marginal cost and revenue, marginal benefit and cost, marginal propensity to consume and save, and marginal product and marginal revenue product.
The first widely recognized application of marginal analysis was developed by the English economist Stanley Jevons who, in 1862, used marginal utility analysis to explain why the price of diamonds was so much higher than a necessity good such as water. Jevons demonstrated that the price of a good was determined by its marginal utility, the extra benefit obtained from an additional unit of the good, not its total utility. While the total benefit or utility of water was clearly greater than that of diamonds, because water is in much greater abundance than diamonds, the marginal utility of purchasing and consuming an additional unit of water was less than that of diamonds, which are much more scarce.
During the late 1800s and early 1900s, economists led by Alfred Marshall used the concept of diminishing marginal utility to explain the law of demand, the inverse relationship between price and quantity demanded that exists in markets. The law of diminishing marginal utility states that the more of a good one obtains in a period of time, the less the additional utility derived from each additional unit of that good. Therefore to induce people to purchase more of a good, the price would have to be lowered. In what is called the equi-marginal principle, to maximize utility or well-being, consumers allocate their scarce incomes among goods so as to equate the marginal utilities per dollar of expenditure on the last unit of each good purchased. If the price of a good decreases, the marginal utility per dollar spent on that good increases, and consumers will adjust their allocation by purchasing more of that good.
Contribution margin, part of break-even analysis, is the difference between average revenue and average variable cost at various levels of output. Average revenue (price for competitive firms) is total revenue divided by quantity sold. Average variable cost is the firm’s total variable costs divided by output. Variable costs are costs that change with the level of output (as opposed to fixed costs, which do not change over a range of output). Contribution margin provides firms with income over the cost of the product, to be used to pay fixed costs and contribute to the firm’s overall profits.
Marginal analysis also includes comparison of marginal cost and marginal revenue. Marginal cost is the added cost of producing one more unit of a good. Marginal revenue is the added revenue from the sale of one more unit of a good. Most business decision making includes marginal analysis. Questions—such as should the firm add another worker, stay open an additional hour, or add a new line of products—are marginal decisions. In each of these situations, managers consider how much more will it cost and how much more revenue will it generate. Many times it is difficult to accurately measure marginal costs and revenues, but conceptually many business decisions are made based on marginal analysis.
Marginal benefit and cost are part of benefit-cost analysis. Benefit-cost analysis is widely used in public-sector decision making. Marginal benefit and cost differ from private decision making in that some benefits or costs to society may not be included in a firm’s analysis, while public-sector resource allocation tries to include direct and indirect benefits and costs, called externalities.
In his General Theory of Employment, Interest, and Money (1936), John Maynard Keynes introduced the concepts of marginal propensity to consume (MPC) and marginal propensity to save (MPS). Marginal propensity to consume is the percentage of additional income individuals will use for consumption expenditures, while marginal propensity to save is the percentage of additional income individuals will use for savings. Together an individual’s MPC plus MPS equals 1. Keynes stated that the impact of a government policy such as a tax cut would depend on consumers’ MPC. A tax cut increases peoples’ incomes, and the higher consumers’ MPC the greater the stimulus effect of a tax cut. Studies have shown that younger people and people with lower income tend to have higher MPCs, which would suggest that tax cuts for college students would have greater impact on an economy than tax cuts for their parents.
Marginal product is the additional output obtained from using one more unit of a variable input in a fixed-production process. For example, marginal product is the extra food produced from adding one worker in a fast-food restaurant. The cooking system is the fixed-production process, and as more workers are added to the system, more food is produced up to the point where workers start bumping into each other and reducing each other’s productivity. At that point marginal product is zero or even negative. Marginal revenue product is the value of the output from using one more unit of a variable input in the fixed-production process. In the above example, marginal revenue product is the value of the extra food produced as more workers are added to the process.
See also competition.