What is Marginal Analysis?

What is Marginal Analysis?

Definition

Marginal analysis can be used to determine the impact on output that results from a small change in input.  A marginal change, usually of one unit, is made in one variable to see the effect that it has on the level of production or on profits.

What does marginal analysis mean?

George Mankiw, an economist at Harvard University, says that marginal analysis is one of the ten most important principles of economics. In his popular economics textbook titled “Principles of Economics,” he says that “rational people think at the margin.”

What exactly does that mean? When an individual makes a decision, it is based on an evaluation of the marginal benefit that it will provide as compared to the marginal cost that it will entail. In other words, what additional benefit will be available and what will the additional cost be? Obviously, a rational person would like the additional benefit to exceed the additional cost.

This principle can be applied in a business situation as well. If it costs a manufacturing firm $150 to employ a temporary worker for a day, it would do so only if the incremental profit by hiring this person is at least $150.

It is important to remember that the process of marginal analysis looks at additional or marginal costs and not at total costs.

Example of marginal analysis

Aether Airlines offers a New York – London flight ticket at $650. The total cost of operating the Boeing 777 that flies between the two cities is $170,000. At full capacity, the aircraft can carry 350 passengers.

Many of its flights operate with several vacant seats. The airline conducts a marginal analysis study that reveals that the cost of flying one additional passenger is only $125. It decides to offer “last-minute” tickets at $375. This provides it with a profit of $250 on each “last-minute” ticket.

If the airline had analyzed its total cost per ticket, it would have arrived at a figure of $486 (total cost of operating the flight, $170,000, divided by 350 passengers). Aether Airlines would have thought that unless it sells tickets at a minimum of $486 each, it would incur a loss.

But, by using marginal analysis, it has been able to increase its revenues and its total profits.

Summary

Marginal analysis uses incremental changes in inputs to determine the impact on output and profits. It is a basic economic principle as well as a useful decision-making tool for businesses.