Marginal thinking is one of the cornerstones of economics and plays an instrumental role in resource allocation. It examines incremental benefit in relation to marginal cost, and helps avoid common decision-making errors like the sunk cost fallacy.
Imagine Bob is caught up in a housing market crash, and finds his house to be worth less than when he bought it. Even though this purchase no longer fits his needs, he might feel compelled to remain committed and continue paying.
Definition
Marginal thinking is the practice of assessing an investment or action by considering its marginal costs and benefits. This practice helps businesses and individuals evaluate whether something is worthwhile undertaking by considering long-term effects of decisions made; opportunity costs associated with forgoing better alternatives; as well as understanding marginal analysis's capabilities that allow businesses to design effective incentives for employees and customers that improve overall economic results.
Marginal analysis is an integral component of modern economics, from its origins in Adam Smith's Law of Diminishing Marginal Returns and tax law all the way through everyday decision-making like choosing how many hours to work or tipping waiters. It serves as the cornerstone of modern decision-making by individuals and companies alike.
As consumers consume one more unit of any good, its marginal benefit and cost decline significantly; these costs correspond to extra expenses associated with producing that unit.
Marginalism has become the cornerstone of microeconomics as an academic discipline, providing business leaders and consumers alike with vital insight into making economic decisions that have wide-ranging repercussions in real life.
Marginal thinking is an invaluable way of optimizing limited resources and time. For instance, understanding marginal thinking allows us to make the best use of limited resources and time available. You might decide to work late if the marginal benefit outweighs any opportunity costs associated with losing some leisure time; similarly a business might invest more heavily in projects offering higher initial returns, as these will likely have greater effects on its profits than later projects.
However, marginal thinking can easily lead to bad decisions that damage both your company and personal finances. Jeffrey Skilling, former CEO of Enron, and Blockbuster (defunct video rental chain), were both victims of marginal thinking when they decided to expand their businesses using methods which seemed short-term profitable but ultimately cost them dearly.
Examples
Marginal analysis allows people to make effective decisions by considering marginal costs and benefits. This decision-making strategy applies to all areas of life; businesses often utilize marginal analysis in order to determine whether new projects or investments will yield returns that justify their costs and effort. When eating pizza, for instance, one might decide that an extra slice might increase grades more than its opportunity cost (lost leisure time). Marginal thinking also plays an important role in business: companies utilize margin analysis in analyzing potential investments.
Marginal thinking can often be misconstrued; individuals often focus too heavily on future benefits and costs without taking into account what has already been invested into a project - this phenomenon is known as the Sunk Cost Fallacy and can lead to poor decisions.
Misunderstandings of marginal thinking often occur when individuals fail to consider the opportunity costs associated with additional purchases, leading them down a path toward wasteful spending. For instance, if an individual wants another ring but already owns one they might forgo purchasing it if the marginal benefit falls below $100; however if that additional ring costs $50 more it might make more financial sense.
Marginal analysis is essential for businesses and governments looking to allocate resources efficiently. For instance, companies might opt to produce more steel using existing facilities whose marginal costs are lower, rather than investing in technology which may cut production costs further. By carefully considering costs and benefits associated with new activities, businesses can increase their profit margins and optimize profits.
Marginal thinking can be an invaluable asset for both individuals and organizations, yet it can also be dangerous. For instance, when making financial plans mistakes that eventually compound and turn into costly errors.
Jeffrey Skilling, the disgraced CEO of Enron and Blockbuster (now defunct video rental company), both fell victim to this trap. Clayton Christensen's book "How Will You Measure Your Life?" provides examples of these leaders ignoring marginal analysis, leading to catastrophic losses. To avoid similar pitfalls yourself, carefully assess all potential consequences of any decision before you implement it.
Application
Understanding this principle and the concept of opportunity cost are fundamental for making decisions and managing finances effectively. Both concepts emphasize evaluating small changes rather than overall costs or benefits and help individuals and businesses allocate their resources more efficiently. They can especially prove invaluable in business decision-making where analyzing marginal costs and benefits is integral in optimizing productivity and profitability.
Marginal thinking can also assist us with making better personal decisions, particularly when making plans for how we spend our free time. When debating whether or not to attend that party tonight, consider what the marginal benefit will be of going - for instance if the enjoyment from that extra slice of pizza exceeds its marginal cost then attending is probably worth your while.
Marginal thinking can be found everywhere in life, from choosing how much to tip at restaurants to making smarter decisions that increase our happiness and satisfaction. By applying this principle to everyday decisions, you can maximize both happiness and satisfaction for maximum happiness and fulfillment.
Marginal analysis can also help us to gain a greater insight into how public opinion and policy evolve over time, showing us how consistent advocacy, awareness campaigns and scientific discoveries can reshape mainstream attitudes and beliefs; for instance, climate change's incremental shift has illustrated just how even small shifts in awareness can have hugely consequential societal effects.
However, marginalism should not be applied rigidly. A company may decide to build a plant based on anticipated marginal benefits and costs ex-ante; but later finding out it won't be profitable could create the "sunk cost fallacy," whereupon much money has already been spent up front on fixed costs like salaries for engineers or rent that is irretrievable.
Finances
Consideration of incremental or additional costs and benefits is vital in making efficient economic decisions, as it enables individuals, businesses, and governments to optimize resources while optimizing financial outcomes.
Thinking on the margin can lead to more efficient resource allocation and an improved understanding of opportunity costs. Incentivization through bonuses or increased wages can further aid this approach; people can weigh the costs and benefits of various options based on what sacrifices are necessary in exchange for those rewards.
Thinking on the margin can be made simpler through spreadsheets that enable companies to calculate and compare total and marginal costs of various options, which is especially useful when considering investments or new product development decisions. Such analyses help businesses figure out where best to allocate funds and resources as well as which opportunities offer the greatest return.
Thinking on the margin can help prevent errors like the "sunk cost fallacy", an error in thinking which causes people to overlook costs already spent in making an evaluation of potential benefits of new actions. For instance, someone who has spent $10 finding parking spots may forget they could have spent that money elsewhere; similarly if a business invested in training employees that have proven unprofitable in the past may neglect to evaluate any additional training needs as being worthwhile investments.
Rational people take action only when the marginal benefit outweighs its marginal cost, which helps explain why some businesses such as Enron's former CEO or Blockbuster went under. According to Clayton Christensen's business theory, such failures demonstrate companies that failed to think on the margin.