Marginal analysis was the heart of early Austrian economics and was quickly adopted into mainstream economics, where it is central to modern microeconomic analysis. Amazingly, many people in business forget all about it on the job.
Marginal analysis explained an old conundrum: why are necessities like water cheap, while luxuries like diamonds are expensive? It seems backward in terms of necessity and utility. Austrian school founder Carl Menger figured this out at about the same time as William Stanley Jevons and Leon Walras. He said that the first pail of water satisfied the strongest want (thirst), while succeeding pails satisfied lesser wants, such as cleaning. In a small village next to a large river, all of the peoples’ uses of water would be filled, making the value of one additional pail of water zero. This is the essence of marginal analysis: look at the value or cost of the last additional unit, the unit “at the margin.”
A hospital adds up the total cost of running the emergency room, divides total cost by the number of visits, and concludes that every patient costs them $2,000. This becomes absurd at 5:00 am, when the ER doctor, nurses and technicians are idle. An additional patient walking in may cost a few dollars’ worth of bandages and sutures, but no other additional expense. Health care probably has the weakest grasp of any industry of the difference between average cost and marginal cost.
Well managed restaurants know that food is about one-third of the cost of a meal. When business is slack, say at 5:00 pm, tables are empty and the staff has little to do. A person who comes in for a $15 dinner adds only $5 to the restaurant’s costs. If the dinner must be discounted to $10 to lure the customer in, it’s still a good deal for the restaurant. Thus we have early bird specials and happy hours.
This approach explains why capital intensive companies such as airlines so often go bankrupt. Their average cost is high, covering the large price tags on aircraft. The marginal cost is relatively low, encompassing fuel, labor and airport fees. When business is weak, like during a recession, airlines compete for passengers on price. They need only cover the marginal cost of the flight to justify the operation. With all the competitors cutting prices, some or all of them fail to earn enough to cover their debt payments. They go bankrupt, but continue to operate, because they are bringing in a little more money than marginal costs, and thus they lose less than if they shut down.
Internet companies are taking marginal analysis to great heights. Let’s advertise on Facebook for more customers. The additional value of each new user can be calculated, as well as the cost of acquiring one additional customer. It’s easy when thousands or even millions of customer interactions can be studied. When a company sells just a few products a month, as a contractor might, then marginal analysis is more guesswork than science. But an educated guess with marginal analysis is still better than an accurate average cost analysis.
As a young corporate economist, I was stunned to learn how many business decisions are based on average costs rather than marginal costs. I saw this in public utilities, mining and banking as well as the many businesses I later consulted for. Corporate leaders must continually reinforce the importance of marginal analysis, even when the actual numbers are educated guesses.
