Marginal Analysis in Economics

Instructor: Beth Loy

Dr. Loy has a Ph.D. in Resource Economics; master's degrees in economics, human resources, and safety; and has taught masters and doctorate level courses in statistics, research methods, economics, and management.

This lesson explains the economic concept of marginal analysis, which is used in economics to help producers and consumers make economic decisions. Variables, scarcity, marginal benefit and cost, and profit maximization are explained.

Marginal Analysis in Economics

Marginal analysis is used in economics to measure the effect of a change in one variable on another variable. A variable could be almost anything, including supply and demand. Two common variables used in economics are price and units sold.

Will our customers eat more, less, or the same amount of pizza if we raise the price? In this case, the two variables are 1) the price of pizza and 2) the number of pizzas sold. The price of pizza would be what we call a control variable. A control variable is something a company controls, such as how many much we charge for each pizza. It makes sense that consumers will likely decrease the number of pizzas they purchase as the price increases, holding all other variables equal.

Profit Maximization Given Scarce Resources

In economics, we look at the choices we make given the resources we have, and many of those resources are scarce. Most of us only have a limited amount of money so we have to make certain economic choices. Money is a scarce resource, and it is the most common resource analyzed in economics.

So, even if the price of pizza stays the same, at some point, customers will want to spend their money elsewhere. Consumers will only eat so many pizzas. The point where our company's revenue decreases with the next pizza made is where a company should produce. This is profit maximization.

marginal analysis graph of profit maximization

How Changing Variables Affects Choices

Let us say we increase the price of our pizzas by one dollar. An increase of a dollar may not affect how many pizzas consumers purchase. Their marginal benefit, the enjoyment they receive as consumers, outweighs their marginal cost, the price of the pizza. That pizza is going to taste really, really good up until they have to pay too much for it!

An increase of five dollars, however, may drastically decrease the number of pizzas our customers purchase. Remember, money is scarce, and consumers may even stop buying pizza all together at a certain price and switch to eating pasta. Once we understand more of why and when consumers make these choices, given their resources, we can find a way to effectively distribute our company resources. This is why we use marginal analysis, to find the optimal price of pizza given the demand for our pizza.

Example: How Changing Variables Affects Profits

For profit-seeking companies, marginal analysis is important because it measures the additional benefits of changing something about one variable that has an effect on another variable. Again, the variable we change is our control variable.

Let's say that you own AOKAY Headgear, and you produce a lightweight headset for $100, but it costs $70 to produce each headset. If you produce 100 of them, your total revenue, the amount of money you bring in, will be $10,000. The total cost, the amount of money needed to produce the headsets, will be $7,000. You make $3,000 in profit.

At the point where you sell 101 lightweight headsets, your total revenue goes up by $100 to $10,100. Here we are changing the control variable, the number of lightweight headsets that are produced. With this production increase, the marginal benefit is $100 for selling this one unit.

Let's assume that at this point you have to hire another employee to help with production and this increases your total cost of producing the 101 lightweight headsets to $15,000. The choice to produce the 101st headset would be a bad choice because the cost of producing that headset increases to $148.51 from $70. Now, your company is losing money, a total of $4,900 when producing 101 headsets at $100. The marginal cost just jumped from $70 for the 100th headset to $148.51 for the 101st headset.

What does this marginal analysis tell us? The cost of producing an additional headset far outweighs the benefit of producing it. Therefore, it is not worth the extra cost of producing another headset. AOKAY Headgear is better off just producing 100 headsets at this time.

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