Marginal analysis A concept employed constantly in microeconomic theory and sometimes in macroeconomic theory, is that of the marginal change

in some economic variable (such as quantity of a good produced or consumed), or even the ratio of the marginal change in one variable to the marginal change in another variable. A marginal change is a proportionally very small addition or subtraction to the total quantity of some variable. Marginal analysis is the analysis of the relationships between such changes in related economic variables. In microeconomic theory, "marginal" concepts are employed primarily to explain various forms of optimizing behavior. For example consumers are seen as striving to maximize their utility or satisfaction. Firms are seen as striving to maximize their profits. The maximum value of such a variable is found by identifying a value of the independent variable such that either a marginal increase or a marginal decrease from that value causes the value of the dependent variable being maximized to fall. For the decision maker pondering how many units of a good to consume or provide to the market, net profit (benefits minus costs) will always be maximized at that level of provision to the market where the marginal benefit derived from adding the last unit equals the marginal addition to total costs of producing or acquiring that last additional unit. Utility: The focus of economics is to understand the problem of scarcity: the problem of fulfilling the unlimited wants of humankind with limited resources. Because of scarcity, economies need to allocate their resources efficiently. Underlying the laws of demand and supply is the concept of utility, which represents the satisfaction a person receives from consuming a good or service. Utility, then, explains how individuals and economies aim to gain optimal satisfaction in dealing with scarcity. Marginal utility: Marginal utility is the additional satisfaction, or amount of utility, gained from each extra unit of consumption. Law of diminishing marginal utility: Marginal utility usually decreases with each additional increase in the consumption of a good. This decrease demonstrates the law of diminishing marginal utility. Because there is a certain threshold of satisfaction, the consumer will no longer receive the same pleasure from consumption once that threshold is crossed. In other words, total utility will increase at a slower pace as an individual increases the quantity consumed. For example, a chocolate bar. Let's say that after eating one chocolate bar your hunger has been satisfied. Your marginal utility (and total utility) after eating one chocolate bar will be quite high. But if you eat more chocolate bars, the pleasure of each additional chocolate bar will be less than the pleasure you received from eating the one before.

This table shows that total utility will increase at a much slower rate as marginal utility diminishes with each additional bar. Notice how the first chocolate bar gives a total utility of 70 but the next three chocolate bars together increase total utility by only 18 additional units. The law of diminishing marginal utility helps economists understand the law of demand and the negative sloping demand curve. The less of something you have, the more satisfaction you gain from each additional unit you consume; the marginal utility you gain from that product is therefore higher, giving you a higher willingness to pay more for it. Prices are lower at a higher quantity demanded because your additional satisfaction diminishes as you demand more. Law of equi-marginal utility: In order to determine what a consumer's utility and total utility are, economists turn to consumer demand theory, which studies consumer behavior and satisfaction. Economists assume the consumer is rational and will thus maximize his or her total utility by purchasing a combination of different products rather than more of one particular product. Thus, instead of spending all of your money on three chocolate bars, which has a total utility of 85, you should instead purchase one chocolate bar, which has a utility of 70, and perhaps a glass of milk, which has a utility of 50. This combination will give you a maximized total utility of 120 but at the same cost as the three chocolate bars.

In order to get maximum satisfaction out of the money we have, we carefully weigh the satisfaction obtained from each rupee that we spend. If we find that a rupee spent in one direction has greater utility than in another, we shall go on spending money, on the first commodity, till the satisfaction derived from the last rupee spent in the two cases is equal. In other words, we substitute some units of commodity of greater utility for some units of the commodity of less utility. The results of this substitution will be the MU of the former will fall and that of the latter will rise in comparison to each other, till the two marginal utilities are equalized. The laws of equi-marginal utility states that a consumer will reach a stage of equilibrium when the marginal utilities of various commodities he consumes are equal. MU of MU of Oranges Apples 1 10 8 2 8 6 3 6* 4^ 4 4^ 2* 5 2 0 6 0 2 7 2 4 8 4 6 Suppose apples and oranges are to be purchased and we have go seven rupees to spend. Let us spend three rupees on oranges and four rupees on apples. The utility of 3rd unit of oranges is 6 and that of the 4th unit of apples is 2. As the MU of oranges is higher, we should buy more of oranges and less of apples. Let us substitute one orange for one apple so that we buy four oranges and three apples. Now the MU of both oranges and apples is the same i.e. 4. This arrangement yields maximum satisfaction. Thus total utility of 4 oranges would be 10+8+6+4=23 and of three apples 8+6+4=18 which gives a total utility of 46. The satisfaction given by 4 oranges and 3 apples of one rupee each is greater than could be obtained by any other combination. Thus, it can be concluded that we obtain maximum satisfaction when we equalize marginal utilities by substituting some units of the more useful for the less useful commodity. This law has been formulated in form of the law of equi-marginal utility. It states that the consumer will spend his money on different goods in such a way that the marginal utility of each good is proportional to its price: MUx / Px = MUy / Py = MUz / Pz, where MU represents marginal utility and P is the price of good. Similarly, a producer who wants to maximize profit will use the technique of production which satisfies the following condition: MRP1 / MC1 = MRP2 / MC2 = MRP3 / MC3, (10/2=20/4=40/8) where MRP is marginal revenue profit and MC represents marginal cost. Thus, a manger can make rational decision by allocating/hiring resources in a manner which equalizes the ratio of marginal returns and marginal costs of various use of resources in a specific use. Marginal and Incremental Principle: This principle states that a decision is said to be rational and sound if given the firms objective of profit maximization, it leads to increase in profit, which is in either of two scenarios: If total revenue increases more than total cost. If total revenue declines less than total cost. Incremental analysis differs from marginal analysis only in that it analysis the change in the firm's performance for a given managerial decision. It refers to changes in cost and revenue due to a policy change. For example, adding a new business, buying new inputs, processing products, etc. Change in output due to change in process, product or investment is considered as incremental change. Incremental principle states that a decision is profitable if: Revenue increases more than costs Costs reduce more than revenues Increase in some revenues is more than decrease in others Decrease in some costs is greater than increase in others.
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Opportunity Cost: By opportunity cost of a decision is meant the sacrifice of alternatives required by that decision. If there are no sacrifices, there is no cost. According to Opportunity cost principle, a firm can hire a factor of production if and only if that factor earns a reward in that occupation/job equal or greater than its opportunity cost. Opportunity cost is the minimum price that would be necessary to retain a factorservice in its given use. It is also defined as the cost of sacrificed alternatives. For instance, a person chooses to forgo his present lucrative job which offers him Rs.50000 per month, and organizes his own business. The opportunity lost (earning Rs. 50,000) will be the opportunity cost of running his own business. Time Perspective Principle: According to this principle, a decision maker should give due emphasis, both to short-term and long term impact of his decisions, giving due significance to the different time periods before reaching any decision. Short run refers to a time period in which some factors are fixed while others are variable. The production can be increased by increasing the quantity of variable factors. While long run is a time period in which all factors of production can be changed. Entry and exit of seller firms can take place easily. From consumers point of view, short run refers to a period in which they respond to the changes in price, given the taste and preferences of the consumers, while long run is a time period in which the consumers have enough time to vary their tastes and preferences. Discounting Principle: According to this principle, if a decision affects costs and revenues in long run, all those costs and revenues must be discounted to present values before valid comparison of alternatives is possible. This is essential because a rupee worth of money at a future date is not worth a rupee today. Money actually has time value. Discounting can be defined as a process used to transform future dollars into an equivalent number of present rupees. For instance, Rs 1 invested today at 10% interest is equivalent to Rs 1.10 next year. FV = PV*(1+r)t, Where, FV is the future value, PV is the present value, r is the discount (interest) rate, and t is the time between the future value and present value.