The Key to Marginal Analysis
Many big changes in the economy occur as small changes take place. These small changes affect such important metrics as costs and profit margins. In the world of economics, examining the effect these changes have is called marginal analysis, and many experts consider it a key factor in analyzing the economy. Marginal analysis examines the additional revenue or benefits from a decision compared with any additional cost. The key to marginal analysis is understanding this relationship between cost and benefits.
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Business Use
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Marginal decisions in a business include considering hiring a new employee, staying open longer, expanding the production of an existing product and launching a new product or service. The heart of margin analysis is the comparison of cost with revenue. The marginal cost is the expenditure incurred when producing an additional unit. The marginal revenue is the amount gained from the sale of the additional unit. If the added revenue or benefits exceed the added costs, then you should implement the concept. You should continue with that concept as long as the revenue outweighs the cost. However, once the revenue equals the cost, stop the process. If the concept's costs outweigh the revenue, then do not take action.
Public Sector Use
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Whereas businesses are primarily concerned with how margin analysis can help the bottom line, nonprofit organizations and government programs use margin analysis a bit differently. Since these organizations are not principally concerned with revenue, they examine the benefits to their audience or members against the cost to implement. This analysis differs from business use because it includes direct and indirect benefits and costs to society. These benefits and costs are called externalities. The product or service should be continued as long as its benefits to society outweigh its costs.
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Strategic Benefits
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When implemented properly, margin analysis provides numerous benefits. First, decision making becomes much more efficient. Decisions are only given a green light if they are profitable. Margin analysis can also help with problem solving because instead of trying to solve numerous issues at one time, it simply looks at each step to maximize efficiency. This strategy can also help reduce the stress of a business owner because marginal analysis allows him to make the best decision on smaller issues. Each of the smaller, incremental decisions should help address the strength of the business overall.
History
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William Stanley Jevons is considered by many as the father of margin analysis. His contributions helped lead to the "marginal revolution," which changed the way economic theory was viewed. In "The Theory of Political Economy" (1871), Jevons used an early form of margin analysis to explain why diamonds were more expensive than water, despite not being nearly as useful. Jevons argued that any product is valued by its marginal utility, not its total utility. Marginal utility is simply a change in satisfaction gleaned from the use or consumption of a product or service. Although water is clearly more useful than a diamond, its cost is substantially less. This is because its marginal utility is diminished due to its great abundance whereas a diamond's marginal utility is increased by its scarcity.
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References
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