The Economy & You #21 – What is Marginalism?
In a previous article (Why Study Economics), I wrote that one of the main reasons to study economics is to develop a new way of thinking. Economics is about the choices we all make regarding scarce resources. In another article, I touched on opportunity cost (CFE 20 – Prince Fielder & Opportunity Cost) and how options that we give up are part of the decision making process.
Another important concept used in decision making is marginalism. Marginalism is the process of analyzing the additional cost or benefit resulting from a specific decision. Why this is important is that when weighing the benefits or costs of a decision, a person should only factor in the benefits and costs that result from that specific decision.
Consider the music business. In this simplistic example, XYZ Records is considering signing Billy Bank & the T-Notes to a record deal. To produce a typical CD, XYZ will spend roughly $250,000 on recording the music, making the video, marketing the album, and producing and distributing the 50,000 CDs to record stores. So the first number XYZ Records must consider is $250,000. XYZ must determine if Billy Bank can sell enough albums for XYZ to recoup their initial investment.
Now that XYZ Records has made its initial investment, the company will need to decide whether it should produce any more CDs than the 50,000 the originally produced. The initial investment of $250,000 should no longer be a factor in deciding whether more money should be spent on behalf of Billy Bank and the band. The money spent is a sunk cost. Sunk costs are costs that have already been spent or incurred and should be irrelevant to further financial decisions. XYZ must turn their attention to the next set of costs. XYZ must decide whether to produce more CDs. Since the additional cost (or marginal cost) of producing one additional CD is approximately $3, the $3 is now the important cost number. If XYZ believes the additional revenue (or marginal revenue) will be greater than the $3 it takes to produce the CD, then the record company will move forward with producing more CDs.
This example demonstrates one of the most important concepts in economics. When marginal revenue (MR) is greater than marginal cost (MC), a company will continue to produce a product until marginal revenue is equal to marginal cost. This is because as long as MR>MC, the company continues to make a profit on each additional good produced.
There are many examples that show how marginal cost and marginal revenue is useful. For a concert promoter that has empty seats at a concert. The empty seats would mean a loss of potential revenue. The marginal cost of the extra concert goers is basically zero. The cost for the band and the venue are sunk costs. Selling the empty seats at a discount will increase the total revenue with essentially no additional cost. Filling those seats at greatly reduced price is still better than the seats being empty. This concept is also used for airlines and cruises.
Marginalism help individuals and companies in the decision making process by determining whether the incremental benefit of an action outweighs the incremental cost. This concept helps provide the optimal choice from a cost-benefit perspective.
- Quick Tip: Recognizing Sunk Costs (choosewhat.com)