MARGINAL ANALYSIS

The process of identifying the benefits and costs of different alternatives by examining the

incremental effect on total revenue and total cost caused by a very small (just
one unit) change in the output or input of each alternative. Marginal analysis
supports decision-making based on marginal or incremental changes to resources instead
of one based on totals or averages.

An examination of the additional benefits of an activity compared to the additional

costs of that activity. Companies use marginal analysis as a decision-making tool to
help them maximize their profits. Individuals unconsciously use marginal analysis to
make a host of everyday decisions.

Example:

In business, the practice of setting the price of a product to equal the extra cost of
producing an extra unit of output is known as marginal-cost pricing. Businesses often set
prices close to marginal cost during periods of poor sales. If, for example, an item has a
marginal cost of $1.00 and a normal selling price of $2.00 the firm selling the item might
wish to lower the price to $1.10 if demand has waned. The business would choose this
approach because the incremental profit of 10 cents from the transaction is better than no
sale at all.

In the marginal analysis of pricing decisions, if marginal revenue is greater than marginal
cost at some level of output, marginal profit is positive and thus a greater quantity should
be produced. Alternatively, if marginal revenue is less than the marginal cost, marginal
profit is negative and a lesser quantity should be produced. At the output level at which
marginal revenue equals marginal cost, marginal profit is zero and this quantity is the one
that maximizes profit.

Since total profit increases when marginal profit is positive and total profit decreases when
marginal profit is negative, it must reach a maximum where marginal profit is zero.

In , the intersection of MR and MC is shown as point A. If the industry is perfectly

competitive (as is assumed in the diagram), the firm faces a demand curve (D) that is
identical to its marginal revenue curve (MR). Thus, this is a horizontal line at a price
determined by industry supply and demand. If the firm is operating in a non-
competitive market, changes would have to be made to the diagram.
Marginal cost is the increase or decrease in the total cost a business will incur by
producing one more unit of a product or serving one more customer.

Formula for Marginal Cost

The formula for marginal costs can be expressed as follows:
Marginal Cost = Change in costs / Change in quantity

For the more algebraically inclined, marginal cost can be also be expressed by this

equation:
DEFINITION OF 'MARGINAL REVENUE - MR'

The increase in revenue that results from the sale of one additional unit of output Marginal
revenue is calculated by dividing the change in total revenue by the change in output
quantity. While marginal revenue can remain constant over a certain level of output, it
follows the law of diminishing returns and will eventually slow down, as the output level
increases

For example, a company producing brooms has a total revenue of $0, when it doesn't
produce any output. The revenue it sees from producing its first broom is $15, bringing
marginal revenue to $15 ($15 in total revenue/1 unit of product). If the revenue from the
second broom is $10, the marginal revenue gained by producing the second broom is $10
(change in total revenue: $25-$15/1 additional unit).
How to Determine Marginal Cost, Marginal Revenue, and Marginal Profit
in Economics
Marginal cost, marginal revenue, and marginal profit all involve how much a function goes
up (or down) as you go over 1 to the right — this is very similar to the way linear
approximation works.
Say that you have a cost function that gives you the total cost, C(x), of producingx items
(shown in the figure below).

The derivative of C(x) at the point of tangency gives you the slope of the tangent
line. Slope equals rise/run, right? So when the run equals 1, the rise equals the slope (which
equals the derivative). On the little triangle under the tangent line, you run across 1 and
then you rise up an amount called the marginal cost. And thus the derivative equals the
marginal cost, get it?
Going 1 to the right along the curving cost function itself shows you the exact increase in
cost of producing one more item. If you look very closely at the right side of the above
figure, you can see that the extra cost goes up to the curve, but that the marginal cost goes
up a tiny amount more to the tangent line, and thus the marginal cost is a wee bit more
than the extra cost (if the cost function happened to be concave up instead of concave down
like it is here, the marginal cost would be a tiny bit less than the extra cost).
So, because the tangent line is a good approximation of the cost function, the derivative
of C — called the marginal cost — is the approximate increase in cost of producing one
more item. Marginal revenue and marginal profit work the same way.
Before doing an example involving marginals, there’s one more piece of business to take
care of. A demand function tells you how many items will be purchased (what the demand
will be) given the price. The lower the price, of course, the higher the demand. You might
think that the number purchased should be a function of the price — input a price and find
out how many items people will buy at that price — but traditionally, a demand function is
done the other way around. The price is given as a function of the number demanded. That
may seem a bit odd, but the function works either way. Think of it like this: if a retailer
wants to sell a given number of items, the demand function tells him or her what the selling
price should be.
Okay, so here’s the example. A Mobile manufacturer determines that the demand function
for her mobile is

where x is the demand for mobile at a given price, p. The cost of producing x mobile is given by the following cost function:

Determine the marginal cost, marginal revenue, and marginal profit at x = 100 mobiles.

Marginal cost
Marginal cost is the derivative of the cost function, so take the derivative and evaluate it at x = 100.

Thus, the marginal cost at x = 100 is $15 — this is the approximate cost of producing the 101st mobile.

Marginal revenue
Revenue, R(x), equals the number of items sold, x, times the price, p:

Marginal revenue is the derivative of the revenue function, so take the derivative of R(x) and evaluate it at x = 100:
Thus, the approximate revenue from selling the 101st mobile is $50.

Marginal profit
Profit, P(x), equals revenue minus costs. So,

Marginal profit is the derivative of the profit function, so take the derivative of P(x) and evaluate it at x = 100.

So, selling the 101st mobile brings in an approximate profit of $35.

By the way, while the above math is exactly what you’d want to do if you were asked only to compute the marginal profit, did
you notice that it was unnecessary in this example? Once you know the marginal cost and the marginal revenue, you can
get marginal profit with the following simple formula:

Marginal Profit = Marginal Revenue – Marginal Cost.