Marginal analysis: Marginal Benefit including marginal revenue and Marginal cost
By: Jeremy Ballard


The word marginal is used frequently in economics. The first thing to remember about marginal is that it deals with changes: how much added revenue was produced from the last unit of product sold, how much additional cost was associated with the last product produced, how much additional satisfaction the last unit of a product consumed yielded to the purchaser. It is important to remember that it is distinguished from averages (Dauffenbach).

Managers use microeconomics in making critical business decisions on a daily basis. Managers can use their understanding of supply and demand to predict business changes. In addition, managers can use marginal analysis to target optimum levels of production to maximize revenues and profits while minimizing costs without trial and error (Argenti, 2002). Managers need to have a basic understanding of the following terms (Baye, 2009):

Marginal Cost: The additional cost incurred by using an additional unit of the managerial control variable.
Mathematical Definition = MC = ΔC/ΔX = slope of the cost function

Marginal Benefit: The additional benefits that arise by an additional unit of the managerial control variable.
Mathematical Definition = MB = ΔB/ΔX = slope of the benefit function

Marginal Revenue: The change in revenue attributable to the last unit of output.
Marginal Contribution: The portion of value created that can be assigned to a specific change, factor, or individual.
Optimal Quantity: The level that generates the maximum possible total net gain
Principal of Marginal Analysis: The optimal quantity of an activity is the quantity at which marginal benefit is equal to marginal cost.
Diminishing Marginal Utility: The more we already have of something, the less satisfaction we will get from an additional unit of it.
Law of Diminishing Marginal Returns: The incremental benefit starts to decrease as you continue to increase the inputs. (time, effort, money)

Marginal Analysis a tool for Employee’s Compensation:

Organizations utilize elements of marginal analysis when developing compensation programs to recognize/reward employees. Below are some of the questions employers try to answer when evaluating an employee’s marginal contribution (Koch, 2007):

· What results were achieved?
· Would the opportunity have been captured without the employee?
· What would the results have been without this individual?
· How did this employee contribute to our culture?

Using this system allows organizations’ to determine which employees are profitable and those whom are unprofitable. If the employee is profitable, he/she is creating more value than their compensation. Conversely, employees who are unprofitable are creating less value than their compensation and wasting organization’s resources. In this situation the employer is determining how to allocate a scarce resource (time) to determine the point where marginal benefit equals marginal cost.

How a Manager/Owner of a company applys Marginal Analysis:
This is a basic example of how to apply the concepts to determine how to best apply his resources to how many lawns to mow maximize profits.

Lawn_Chart.jpg


In the example above, the additional cost of mowing an additional lawn goes up and thus Pete’s marginal cost increases with each lawn he mows. At the same time, each additional lawn Pete mows results in less benefit or has a decreasing marginal benefit. The optimal number of lawns Pete should mow is 5 as this is where Pete’s total net gain is maximized ($33.25). Pete could also reference his total net gain as profit.

Note: The demand curve is the same as the marginal benefit (MB) curve and the supply curve is the same as the marginal cost (MC) curve. The market price and quantity are determined by the intersection of demand and supply (E), or MB and MC (BasicEconomics.com). In the example of above, Q* would be 5.

MB,_MC.JPG
Summary that can used to determine the optimal number of lawns he should mow:
n If marginal benefit > marginal cost
q Activity should be increased to reach highest net benefit
n If marginal cost > marginal benefit
q Activity should be decreased to reach highest net benefit
n Optimal level of activity
q When no further increases in net benefit are possible
q Occurs when MB = MC

Caution when performing Marginal Analysis:
Marginal analysis and the efficiency standard are extremely useful tools to approaching complex problems. However, the efficiency standard generally has nothing to say about the morality or fairness of a particular decision. Equity and efficiency are two different things. One must not use the efficiency standard indiscriminately or else he/she can arrive at some ridiculous or dangerous conclusions.

For example, suppose the law mandates that the water in a town be cleaned to the point until the marginal costs to society exceed the marginal benefits. At this level, the water is still too dirty to swim in and children who drink from the water are exposed to lead poisoning. Society may decide to clean up the water even more than the efficient level because we do not want to harm children. Even though the solution may not be efficient, it may be fairer (Humbolt.edu).

How a Manager/Owner of a company applys Marginal Revenue Analysis:
The lawn care business is very competitive. The following are characteristics of the pure competition market Pete’s lawn care company operates in:

1. All firms sell an identical product.
2. All firms are price takers.
3. All firms have a relatively small market share.
4. Buyers know the nature of the product being sold and the prices charged by each firm.
5. The industry is characterized by freedom of entry and exit.

How much additional revenue does the Pete get if he mows one additional lawn? To answer this question, Pete would perform marginal revenue analysis to examine how much additional value each lawn he mows brings to the firm (marginal revenue) compared to the cost to mow the additional lawn (marginal cost), he could do so by utilizing the chart below. (Baye, Tutor2u.net)
a2-micro-profits_clip_image001.gif
In order for Pete to maximize profit, he needs to know the revenue and costs of his lawn care business. Pete’s profits are maximized when marginal revenue equals marginal cost. Recall that marginal revenue is the additional revenue from one additional unit. Marginal cost is the additional cost from one additional unit. Since marginal cost is upward sloping, as price increases, the number of lawns mowed (quantity) will increase too. As price falls, the number of lawns mowed (quantity) falls. In each case, the marginal cost curve determines how many lawns Pete is willing to mow at each price. As mentioned above, this translates into the supply curve (Hoag, 2006).

Summary of profit maximization:
n If marginal revenue > marginal cost (revenue is increasing faster than costs)
q Firm should increase production
n If marginal revenue < marginal cost (revenue is less than additional costs)
q Firm should decrease production
n Firm maximizes profits
q Occurs when MR = MC

Effects of Entry on Output and Profit:
Fortunately Pete’s lawn care company is generating a profit. However, due to the lawn care industry being perfectly competitive, there are no barriers to entry and other greed capitalists are able to enter. This entry into the industry will have the following effects on Pete’s business (Baye, 2009):
  1. Entry increases market supply, drives down the market price and increases market quantity
  2. Demand for shifts down
  3. Reduction of output to maximize profit
  4. Long run profits are zero

Due to the entry into the market,
total revenue is greater than total cost (P > AC), Pete’s lawn care company may have to make the decision to either temporarily or permanently shutting down the company if profits decline due to the increased competition. The rule of thumb that Pete should use is the following (Baye, 2009):
    • Continue mowing lawns as long as P ≥ AVC
    • Close the doors when P < AVC
PATC.JPG
Summary:

The core of microeconomics is marginal analysis. As long as the benefits of each step outweigh its cost, the step should be taken. However, once the step’s cost exceeds its benefit, the step should not be taken. The following is the basic procedure of marginal analysis (Wessels, 1997).

Step1 – Break an Action into Small units
Goal: Maximize the net benefit from taking the action:
Net Benefit = Total benefits – Total Cost
Step 2 – Calculate the Benefits from adding another unit
Marginal benefit = Change in total benefits (due to adding another unit)
Step 3 – Calculate the Cost of adding another unit
Marginal Cost = Change in total cost (due to adding another unit)
Step 4 – Take step if Marginal Benefits exceed or equal Marginal Costs
Marginal benefit ≥ Marginal Cost
If this is the case, you are adding more to total benefits than total cost, so the net benefits are gong up by:
Change in net benefit = Marginal Benefit – Marginal Cost



Questions:
Pete has hired you to calculate the costs and revenues for his lawn care company. Pete has provided you with the data below and should be used for questions 1-4.

Question_Chart.jpg

1) What is the total revenue (TR) of mowing the 4th lawn?
a. 10
b. 20
c. 30
d. 40

Answer: D = Q*P = 4 * 10

2) What is the marginal revenue (MR) of mowing the 5th lawn?
a. 2
b. 4
c. 8
d. 10

Answer: D = TR 5 - TR 4 = $50 - $40

3) What is the marginal cost (MC) of mowing the 6th lawn?
a. 8
b. 10
c. 12
d. 30

Answer: C = TC 6 - TC 5 = $60 - $48

4) What profit would Pete achieve by mowing the 4th lawn?
a. 0
b. 2
c. -2
d. -4

Answer: B = TR 4 - TC 4 = $40 - $38

5) If marginal benefit > marginal cost the activity should be?
a. increased to reach highest net benefit
b. decreased to reach highest net benefit
c. do nothing at all

Answer: A

Complete Answer Chart:
Revised_Answer_Key.jpg

References:
Argenti, Paul A. (2002). The Fast Forward MBA Pocket Reference. (2nd Edition). John Wiley and Sons.
Baye, Michael R. (2009). Managerial Economics and Business Strategy. (6th ed.). New York: McGraw Hill.
Dauffenbach, Dr. Robert C. ”What is this thing called Marginal?” Director for Center of Economic and Management Research at University of Oklahoma.
Hoag, Arleen J. (2006). Introductory Economics. (4th ed.). World Scientific.
Koch, Charles G. (2007). The Science of Success. Hoboken: John Wiley & Sons, Inc.
Wessels, Walter J. (1997). Mircoeconomics the Easy Way. Barron’s Educational Series.

http://www.basiceconomics.info/perfect-competition.php
http://sorrel.humboldt.edu/~economic/econ104/marginal/
http://tutor2u.net/economics/revision-notes/a2-micro-profits.html