What is Marginal Analysis? Definition, Uses, and Limitation

Every firm is always looking for new methods to improve its efficiency and decision-making abilities. There are several approaches to this, one of which is Marginal Analysis.

 

Managers can use marginal analysis to compare the benefits of manufacturing activity to the expenses to determine if the activity is profitable. Knowing how to utilize marginal analysis and how it compares to other decision-making methods will help the company decide if this strategy is right for their firm.

 

Let us understand what marginal analysis is, in this blog.

 

What is Marginal Analysis?

 

A study of the additional advantages of activity in comparison to the additional expenditures paid by the same activity is known as marginal analysis. It is a decision-making strategy used by businesses to help them optimize their prospective revenues.

                                                                                                                                                                                                                         

The focus on the cost or benefit of the next unit or individual, such as the expense of producing one more widget or the profit made by hiring one more worker, is referred to as marginal.

 

Marginal analysis is a microeconomic technique. In microeconomics, the majority of decisions are made by determining if the benefit of a certain activity or action outweighs the cost. 

 

When making a choice requiring a causal link involving two variables, marginal analysis comes in helpful. It demonstrates how some conditional modifications might affect a corporation as a whole as explained by Investopedia.

 

 

Marginal Cost vs Marginal Benefit:

 

Now, one must not confuse marginal benefit with marginal cost. Both of them are parts of marginal analysis, but:

 

1. Marginal Cost:

 

The extra cost incurred in the manufacture of additional units of products or services, most commonly utilized in manufacturing, is known as marginal cost. It's derived by dividing the change in expenses by the change in quantity, and it includes both fixed and variable costs for things that have already been created.

 

2. Marginal Benefit:

 

The difference we get when we choose a different decision is known as a marginal benefit. This is the increased money a corporation obtains when it boosts output and/or sells more things in the business world.

 

 

Calculating Marginal Cost:

 

The following is the formula for determining marginal cost:

 

Marginal cost = Change in costs / Change in quantity

 

Where,

 

The Change in cost is calculated by subtracting the first output run's production costs from the second output run's production costs.

 

And, by subtracting the number of goods produced in the first run from the volume of output in the second, we can compute the change in quantity.

 

Also Read | Marginal Utility Theory

 

How does marginal analysis help in decision-making?

 

According to the corporate finance institute, marginal analysis is a critical component in the microeconomic analysis of decisions because it follows two profit maximization rules. They are as follows:

 

1. Equilibrium Rule:

 

According to the first rule, an activity must be carried out until its marginal cost equals its marginal revenue. At this moment, the marginal profit is zero. If marginal revenue exceeds marginal cost, profit may usually be raised by increasing the activity.

 

The marginal benefit measures how the value of cost varies from the consumer's perspective, whereas the marginal cost measures how the value of cost changes from the producer's perspective. 

 

According to the equilibrium rule, units will be acquired up to the point of equilibrium, where a unit's marginal income equals its marginal cost.

 

2. Efficient allocation rule:

 

The second rule of profit maximization using marginal analysis argues that an activity should be carried out until every unit of effort returns the same marginal return. 

 

The rule is based on the assumption that a corporation with several products should split a factor between two manufacturing activities so that each generates the same marginal profit per unit.

 

If this goal is not met, profit can be gained by allocating more resources to the activity with the highest marginal profit and less to the other.

 

 

Marginal Analysis and Opportunity cost:

 

You must first comprehend opportunity cost to comprehend the cost and value of specific actions. When you pick one choice over another, you lose out on a valued advantage called an opportunity cost.

 

Let us study a real-life case. Managers should be familiar with the idea of opportunity cost as well. Assume that a manager is aware that there is funding available to recruit a new employee. According to marginal analysis, adding a manufacturing worker delivers a net marginal gain to the management. This does not imply that hiring is the best option.

 

Assume the manager is also aware that adding a salesman increases the net marginal benefit even more. Hiring a factory worker is the incorrect option in this scenario since it is inefficient.

 

Also Read | Cost-benefit Analysis: Process, Benefits, and Limitations

 

Where is marginal analysis used?

 

Managers can use marginal analysis to design controlled experiments based on observed changes in certain variables. The tool, for example, may be used to assess the cost and revenue effect of raising output by a certain percentage. When the marginal cost is decreased or increasing revenues cover and spill over total production expenses, a profit is obtained. 

 

Marginal analysis of the costs and benefits is required when a manufacturer seeks to expand its operations, either by adding new product lines or expanding the number of items produced from the present product line. 

 

The cost of more production equipment, any additional staff needed to support an increase in output, huge facilities for producing or storing completed items, and the cost of additional raw materials to make the goods are just a few of the factors to consider.

 

Let us take this example by indeed.com, considering the case of a t-shirt manufacturer that is debating whether or not to boost output. They need $0.80 worth of cloth for each shirt they make. 

 

• Monthly fixed costs for the t-shirt firm are $200. If you produce 100 shirts each month, each t-shirt will cost you $2.00 in fixed expenses. That means each garment will set you back $2.80. 

• However, if the corporation decides to boost output to 200 shirts per month, each shirt's fixed cost will drop to $1.00. 

• Assuming that the cost of materials remains constant, the total cost of the shirt is $1.80. In this case, increasing production decreases marginal costs dramatically.

 

Managers frequently find themselves in circumstances where they must choose between many possibilities. 

 

Consider the situation when a corporation has just one job opportunity and must choose between employing a junior administrator or a marketing manager. The firm may have resources to develop, but the market may be saturated, according to a marginal analysis. As a consequence, hiring a marketing manager rather than an administrator will generate better results.

 

Also Read | What are marketing and its principles?

 

Limitations of Marginal Analysis:

 

Here are the limitations of marginal analysis:

 

1. One of the critiques levelled by marginal analysis is that, by its very nature, marginal data is fictitious, and so cannot offer an accurate picture of marginal cost and production when making decisions and replacing items. As a result, considering that most judgments are based on average data, it occasionally falls short of making the ideal decision.

 

2. The influences of psychology, or those fields that now incorporate behavioural economics, are now included in modern marginalism techniques. One of the most fascinating developing areas of current economics is reconciling neoclassical economic concepts and marginalism with the growing literature of behavioural economics.

 

3. Another drawback of marginal analysis is that economic actors make decisions based on expected outcomes rather than actual outcomes. The marginal analysis will be useless if the projected revenue does not materialize as expected.

 

4. Economic agents make marginal decisions depending on how valuable they are in the ex-ante sense since marginalism entails subjectivity in valuation. As a result, minor judgments may be viewed as regrettable or incorrect after the fact.

 

Bottom Line:

 

When two possible investments exist but only enough finances are available for one, marginal analysis can aid in the decision-making process from a microeconomic viewpoint. It may be established whether one option will result in more profits than another by examining the related costs and expected benefits.

 

This is an introductory blog to marginal analysis where we learn about the definition, uses, and limitations of marginal analysis. 

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