The word marginal is used frequently in economics. The first thing to remember about marginal is that it deals with changes: how much added revenue was produced from the last unit of product sold, how much additional cost was associated with the last product produced, how much additional satisfaction the last unit of a product consumed yielded to the purchaser. It is important to remember that it is distinguished from averages (Dauffenbach).
Managers need to have a basic understanding of the following terms:
Marginal Cost: The additional cost incurred by using an additional unit of the managerial control variable.
Marginal Benefit: The additional benefits that arise by an additional unit of the managerial control variable.
Marginal Revenue: The change in revenue attributable to the last unit of output.
Marginal Contribution: The portion of value created that can be a assigned to a specific change, factor, or individual.
Optimal Quantity: The level that generates the maximum possible total net gain
Principal of Marginal Analysis: The optimal quantity of an activity is the quantity at which marginal benefit is equal to marginal cost.
Diminishing Marginal Utility: The more we already have of something, the less satisfaction we will get from an additional unit of it.
Law of Diminishing Marginal Returns: The incremental benefit starts to decrease as you continue to increase the inputs. (time, effort, money)
Managers use microeconomics in making critical business decisions on a daily basis. Managers can use their understanding of supply and demand to predict business changes. In addition, managers can use marginal analysis to target optimum levels of production to maximize revenues and profits while minimizing costs without trial and error.
Organizations utilize elements of marginal analysis when developing compensation programs to recognize/reward employees. Below are some of the questions employers try to answer when evaluating an employee’s marginal contribution (Koch):
What results were achieved?
Would the opportunity have been captured without the employee?
What would the results have been without this individual?
How did this employee contribute to our culture?
Using this system allows organizations’ to determine which employees are profitable and those whom are unprofitable. If the employee is profitable, he/she is creating more value than their compensation. Conversely, employees who are unprofitable are creating less value than their compensation and wasting organization’s resources.
Let’s examine the example below to apply marginal analysis to a basic real work situation.
No. of Lawns Mowed / Pete's Total Cost / Pete's Marginal Cost per Lawn Moved / Pete's Total Benefit / Pete's Marginal Benefit per Lawn Moved / Pete's Marginal Net Gain per Lawn Moved / Pete's Total Net Gain(MB - MC)
0 / 0.00 / 0.00 / 0.00
5.25 / 17.50 / 12.25
1 / 5.25 / 17.50 / 12.25
5.50 / 15.00 / 9.50
2 / 10.75 / 32.50 / 21.75
6.75 / 13.50 / 6.75
3 / 17.50 / 46.00 / 28.50
7.75 / 11.00 / 3.25
4 / 25.25 / 57.00 / 31.75
9.00 / 10.50 / 1.50
5 / 34.25 / 67.50 / 33.25
10.50 / 9.50 / -1.00
6 / 44.75 / 77.00 / 32.25
11.50 / 9.00 / -2.50
7 / 56.25 / 86.00 / 29.75
14.75 / 8.50 / -6.25
8 / 71.00 / 94.50 / 23.50
In the example above, the additional cost of mowing an additional lawn goes up and thus Pete’s marginal cost increases with each lawn he mows. At the same time, each additional lawn Pete mows results in less benefit or has a decreasing marginal benefit. The optimal number of lawns Pete should mow is 5 as this is where Pete’s total net gain is maximized ($33.25). Pete could also reference hit total net gain as profit.
If Pete was to perform marginal revenue analysis to examine the value of each additional lawn he mows brings to the firm (marginal revenue) compared to what that lawn costs (marginal cost), he could do so by utilizing the chart below. (Baye)
If marginal revenue (MR) is greater than marginal cost (MC) the firm’s profits are increasing. Conversely, a firm will experience decreasing profits when marginal revenue (MR) is less than marginal cost (MC).
In summary, the core of microeconomics is marginal analysis. As long as the benefits of each step outweigh its cost, the step should be taken. However, once the step’s cost exceeds its benefit, the step should not be taken. The following is the basic procedure of marginal analysis (Wessels).
Step1 – Break an Action into Small units
Goal: Maximize the net benefit from taking the action:
Net Benefit = Total benefits – Total Cost
Step 2 – Calculate the Benefits from adding another unit
Marginal benefit = Change in total benefits (due to adding another unit)
Step 3 – Calculate the Cost of adding another unit
Marginal Cost = Change in total cost (due to adding another unit)
Step 4 – Take step if Marginal Benefits exceed or equal Marginal Costs
Marginal benefit ≥ Marginal Cost
If this is the case, you are adding more to total benefits than total cost, so the net benefits are gong up by:
Change in net benefit = Marginal Benefit – Marginal Cost
Questions:
Pete has hired you to calculate the costs and revenues for his lawn care company. Pete has provided you with the data below and should be used for questions 1-4.
1) What is the total revenue (TR) of mowing the 4th lawn?
2) What is the marginal revenue (MR) of mowing the 5th lawn?
3) What is the marginal cost (MC) of mowing the 6th lawn?
4) What profit would Pete achieve by mowing the 4th lawn?
5) At what point would profit maximization occur?
Answers:
1)