Marginal analysis is used to determine the incremental change in profit or other benefit associated with several possible alternatives. The outcome of the analysis is used to decide which alternative to pursue. A rational decision maker should always pick the alternative that provides the greatest incremental gain. This concept is used in business to maximize an organization's profits.
The marginal analysis concept can be applied to many decisions, such as:
- Manufacturer decision: Whether to sell additional units to a customer at a reduced price.
- Personal decision: Whether to work additional hours in the office or take a vacation.
- Government decision: Whether to fund a public program to provide more services to taxpayers.
For example, a business owner receives an order from a customer for 100 green widgets at a price of $18 each. The business owner knows that he can earn a profit on 80 of these units, after which he will have to pay an overtime premium to his production staff, which will make the remaining 20 units unprofitable. This marginal analysis indicates that he should accept an order for 80 units, but not for 100 units.
As another example, a motorcycle manufacturing company is producing at close to its full capacity. There still appears to be additional demand in the marketplace, but management is reluctant to invest in the construction of an additional production facility. Instead, management elects to gradually expand the current production facility in very small increments and see if the organization is still earning a profit as each expansion is completed.
Marginal analysis is also known as incremental analysis.