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. Individuals unconsciously use marginal analysis as well, to make a host of everyday decisions.
BREAKING DOWN ‘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.
Example of Marginal Analysis in the Manufacturing Field
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.
Comparing Multiple Options
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 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 profit is the profit earned by a firm or individual when one additional unit is produced and sold. It is the difference between marginal cost and marginal product (also known as marginal revenue), and is often used to determine whether to expand or contract production, or to stop production altogether. Under mainstream economic theory, a company will maximize its overall profits when marginal cost equals marginal product, or when marginal profit is exactly zero.
BREAKING DOWN ‘Marginal Profit’
Marginal profit is different from average profit, net profit, or other measures of profitability in that it looks at the money to be made on producing one additional unit. It accounts for scale of production because as a firm gets larger, its cost structure changes – and, depending on economies of scale, profitability can either increase or decrease as production ramps up.
How to Calculate Marginal Profit
Marginal cost (MCMC) is the cost to produce one additional unit and marginal product (MP) is the revenue earned to produce one additional unit.
Marginal Product (MP) – Marginal Cost (MCMC) = Marginal Profit (MP)
In modern microeconomics, firms in competition with each other will tend to produce units until marginal cost equals marginal product (MCMC=MP), leaving effectively zero marginal profit left for the producer. In fact, in perfect competition there is no room for marginal profits as competition will always push the selling price down to marginal cost, and a firm will operate until marginal product equals marginal cost; therefore, not only does MC=MP, but MC=MP=price.
If a firm cannot compete on cost and they operate at a marginal loss (negative marginal profit), they will eventually cease production. Profit maximization for a firm occurs, therefore, when it produces up to a level where marginal cost equals marginal product and the marginal profit is zero.
Variables to Consider
It is important to note that marginal profit is simply the profit earned to produce one additional item, and not the overall profitability of a firm. In other words, a firm should stop production at the level where producing one more unit begins to reduce overall profitability.
Of course, in reality, many firms do operate with marginal profits that do not equal zero. This is because very few markets actually approach perfect competition due to technical frictions, regulatory and legal environments, and lags and asymmetries of information. Managers of a firm may not know in real time their marginal costs and revenues, which means they often must make decisions on production in hindsight and estimate the future.