Marginal analysis is all about weighing marginal benefit -- the added benefit of having one more unit -- against marginal cost -- the corresponding expense of that additional unit. Marginal analysis is simply deciding whether marginal benefit exceeds marginal cost and acting accordingly.
A business owner asks whether the additional revenue to be gained by producing one more unit will exceed the additional cost of producing it. Consumers make their choices by measuring the satisfaction of buying one more against the cost of buying it. As a general rule, if the marginal benefit of doing something is greater than the marginal cost, it's wise to do it. If the marginal cost of doing something is greater than the marginal benefit, it's wise not to do it.
Marginal Revenue Versus Marginal Cost
Production decisions are also made at the margin. A profit-driven manufacturer will expand its production as long as the marginal revenue derived from producing one more unit is greater than the cost of doing so. If the firm produces so much that the marginal cost exceeds the marginal revenue, it will reduce its production level to the point where marginal cost and marginal revenue are equal.
Marginal Benefit Versus Marginal Cost
Personal choices are made at the margin as well. Whether you should see a movie or go bowling this Friday night -- if those are your entertainment choices -- hinges on the incremental satisfaction you will gain from the entertainment you select. If you have been bowling for the past three weeks, the additional satisfaction gained from a fourth week may not be as much as you will experience by going to see a blockbuster new release at the movie theater. Likewise, when you visit an all-you-can-eat buffet restaurant, the number of times you go back for more is determined at the margin. With each return trip to the buffet, you ask yourself if you really want more food or are beginning to feel bloated. Studying for an exam presents the same decision-making choice: Will an additional hour of studying raise your grade enough to justify the time spent?
The Paradox of Water and Diamonds
The classic example of marginal analysis is the paradox of water and diamonds. Water is a necessity of life, while diamonds are not. Yet water is cheap, while the diamonds are expensive. The answer to this paradox involves marginal utility -- how much satisfaction a person gets from consuming one more unit. Water is plentiful in most parts of the world, so the cost of obtaining one more glass -- and the additional satisfaction derived from it -- is minimal. Diamonds, on the other hand, are scarce. Because they are scarce, consumers derive greater incremental satisfaction from owning them and the price is high.