Marginal Analysis

Site: Saylor Academy
Course: ECON101: Principles of Microeconomics
Book: Marginal Analysis
Printed by: Guest user
Date: Wednesday, October 20, 2021, 6:13 PM

Description

Read this article to learn about one of the fundamental terms in economics: marginal analysis. Specifically, understand the concept of marginal benefit and marginal cost and what is meant in economics when we say that individuals make rational choices at the margin. Also, complete the problems in the "Try It" box and check your answers.

Learning Objectives

  • Explain the importance of marginal analysis in economics
  • Give examples of marginal cost and marginal benefit

Source: Lumen Learning, https://courses.lumenlearning.com/wmopen-microeconomics/chapter/marginal-analysis/
Creative Commons License This work is licensed under a Creative Commons Attribution 4.0 License.

A Little More or a Little Less

The budget constraint framework helps to illustrate that most choices in the real world are not about getting all of one thing or all of another ­– we rarely decide "all burgers" or "all bus tickets". Options usually fall somewhere on a continuum, and the choice usually involves marginal decision-making and marginal analysis.

Marginal decision-making means considering a little more or a little less than what we already have. We decide by using marginal analysis, which means comparing the costs and benefits of a little more or a little less.

It's natural for people to compare costs and benefits, but often we look at total costs and total benefits, when the best choice requires comparing how costs and benefits change from one option to another. In short, you might think of marginal analysis as "change analysis". Marginal analysis is used throughout economics. This subtle concept is easier to grasp with examples.

Marginal Cost

Figure 1. Charm Bracelet. What is the marginal cost of getting more silver heart charms? Should you buy just one charm for $4, or all of them for $12?

Generally speaking, marginal cost is the difference (or change) in cost of a different choice. From a consumer's point of view, marginal cost is the additional cost of one more item purchased. From a business's point of view, marginal cost is the additional cost of one more item produced.

Suppose you typically spend a week at the beach for vacation, but this year you earned an annual bonus from your job. Should you rent a beach house for one week or two? A one-week rental costs $2,000. A two-week rental costs $3,600. Holding everything else constant, which option is better? If you stay for two weeks, the cost is significantly higher: $3,600 versus $2,000. But consider the cost by week. The first week costs $2,000. The difference in cost between one week and two is $3,600 – $2,000, or $1,600. Thus, while the marginal cost of the first week's rental is $2,000, the marginal cost of the second week's rental is $1,600. This illustrates the key rule of marginal analysis: Marginal cost = the change in total cost from one option to another.

Consider another example. Imagine that you're out getting ice cream with your friends or family. You can choose whether to buy one, two, or three scoops of ice cream. One scoop costs $3.00, two scoops cost $5.00, and three scoops cost $7.00. This information is shown in the following table.

Scoops of Ice Cream 1 2 3
Total Cost $3 $5 $7


What is the marginal cost of each scoop of ice cream? The marginal cost of the first scoop of ice cream is $3.00 because you have to pay $3.00 more to get one scoop of ice cream than you do to get zero scoops of ice cream. The marginal cost of the second scoop of ice cream is $2.00 because you only need to pay two more dollars to get two scoops than you need to pay to get one scoop. The marginal cost of the third scoop is also $2.00 because you would need to pay an additional two dollars to get that third scoop.

Scoops of Ice Cream 1  2 3
Marginal Cost $3 $2 $2


Marginal costs sometimes go up and sometimes go down, but to get the clearest view of your options, you should always try to make decisions based on marginal costs, rather than total costs.

Try It

Question 1

The local farmer's market offers 1 bag of romaine lettuce for $5 or 2 bags for $8. What's the marginal cost of the second bag?

marginal cost = $____

Answer to Try It

  • 3

Marginal Benefit

Generally speaking, marginal benefit is the difference (or change) in what you receive from a different choice. From a consumer's point of view, marginal benefit is the additional satisfaction of one more item purchased. From a business' point of view, marginal benefit is the additional revenues received from selling one more item.

Suppose you're considering membership at the local recreation center. The basic membership gives access to the swimming pool, while the full membership gives access to the swimming pool and the weight room. What is the difference between the two memberships? Since both give access to the pool, the marginal benefit of full membership is access to the weight room.

The amount of benefit a person receives from a particular good or service is subjective; one person may get more satisfaction or happiness from a particular good or service than another. For example, you might enjoy ice cream more than your friend who is allergic to dairy. The amount of benefit you get can also change. For example, you might enjoy the ice cream more on a hot day than on a cold day. This doesn't make it any less real, however.

Economic Rationality Revisited

How, then, do you decide on a choice? The answer is that you compare, to the best of your ability, the marginal benefits with the marginal costs. An economically rational decision is one in which the marginal benefits of a choice are greater than the marginal costs of the choice.

If we return to the recreation center example above, suppose that the basic membership is $30 per month, while the full membership is $40 per month. An economically rational decision-maker would ask, Is the marginal benefit (access to the weight room) worth the marginal cost (an extra $10 per month)? For some people, the answer will be yes. For others, it will be no. Either way, marginal analysis is an important part of economic rationality and good decision-making.

Try It

Peyton and Paul are brothers who own a manufacturing business and are considering opening a new distribution center. They estimate that the project would add $5 million in expenses and that their profit would increase by $1.5 million per year for the next 5 years (other things equal). Peyton and Paul decide

    • Not to go ahead with the project because the marginal cost it too high.
    • to go ahead with the project because the marginal cost of the expansion project is low compared to other similar projects.
    • to go ahead with the project because the expected marginal benefit ($7.5 million over 5 years) is greater than the estimated marginal cost of the project ($5 million).

Answer to Try It

    • Not to go ahead with the project because the marginal cost it too high.
      Incorrect. Considering the marginal cost without the marginal benefit can be misleading. The magnitude of the cost is less important than its relationship to the benefits. As long as potential benefits outweigh the cost, it is an action worth taking.
    • to go ahead with the project because the marginal cost of the expansion project is low compared to other similar projects.
      Incorrect. Considering the marginal cost without the marginal benefit can be misleading. The magnitude of the cost is less important than its relationship to the benefits. As long as potential benefits outweigh the cost, it is an action worth taking.
    • to go ahead with the project because the expected marginal benefit ($7.5 million over 5 years) is greater than the estimated marginal cost of the project ($5 million).
      Correct. An actions is worth taking when the marginal cost is less than the marginal benefit. The potential additional profit is greater than the added expenses.

Try It

  1. Suppose the relationship between your study time and your grade on a History midterm is given by the following table:
If you study forYour grade will be
4 hours82
5 hours91
6 hours94

What is the "marginal grade improvement (MGI)" of the 5th hour of studying?

____ points

2. What is the "marginal grade improvement (MGI)" of the 6th hour of studying?

____ points

3. Why might the MGI be diminishing?

Answer to Try It

  1. 9
  2. 3
  3. One reason might be that too much studying in one night results in the student not getting enough rest, and so causes diminishing marginal learning.


Glossary

marginal analysis:
examination of decisions on the margin, meaning comparing costs of a little more or a little less

marginal benefit:
the difference (or change) in what you receive from a different choice

marginal cost: 
the difference (or change) in cost of a different choice