Marginal Analysis: Thinking Incrementally
Marginal analysis enables people to get the greatest value from resources when they make decisions. Economists believe you should continue engaging in an activity as long as the marginal benefit is greater than or equal to the marginal cost.
Marginal benefit (MB) is the change in total benefits that occurs if an activity increases by one unit. When a firm sells one more unit of a good to a consumer, the marginal benefit is the money they receive when one more unit is sold. Here, the marginal benefit is commonly known as marginal revenue.
Marginal cost (MC) is the change in total cost that occurs if an activity increases by one unit. When a firm hires one more employee in a competitive labor market, the marginal cost is the wage that must be paid to one more employee. When a consumer buys one more unit of a good, the marginal cost is the price that is paid for one more unit.
Assuming (as economists do) that people behave in their own best interests, then incremental thinking—that is, marginal analysis—leads to the right decision. For example, you and two friends pay $10 to attend a movie on Friday evening that the critics gave five stars. Forty-five minutes into the movie you all agree that the film doesn't even rate one star. One friend wants to leave and go to your house and play pool, but other friends argue that you should see the rest of the film because you have paid for it. They turn to you to resolve their dispute, and it's an easy decision—you favor going to play pool.
On the way to your house, you explain to your friends how marginal analysis led to your decision. In this situation, it was how to spend the rest of Friday evening after you had already started watching the movie. Once you started watching the movie, the cost of a ticket was what economists call a sunk cost; that is, it's an outlay that once made cannot be recovered. The trade-off you faced was spending another hour and one-half watching a boring movie or playing pool.
In addition to keeping sunk costs from distorting your decision, you explain that marginal analysis means that decisions are reached by weighing additional costs against additional benefits. In this case, the benefit of playing pool is greater than the benefit of watching the rest of the movie. So, despite the fact that you had spent money and time watching the movie, your best choice was to play pool. If you had let sunk costs (that is, the money and time spent watching the movie) dictate your decision, you would have spent the hour and one-half in a less gratifying activity.
While marginal analysis can be used to salvage an evening on the town, it also guides businesses to maximize profits. A business will continue to expand sales and output to the point that the incremental cost of providing the particular good or service equals the price of that good or service.
Let’s see how it works:
Suppose that a local firm hires labor at an hourly wage of $20 to produce T-shirts that sell for $10. The firm’s production process is reflected in the following table. Compute the marginal product of labor as the change in the output of T-shirts when one more person is hired. Compute total revenue as the price ($10) times the output of T-shirts. Compute marginal benefit as the change in total revenue that occurs when one more person is hired. The marginal cost is the wage of $20. Total labor costs are the product of the wage and the number of employees. Net revenue is total revenue less total labor costs.
How many employees should the firm hire to maximize net revenue?