Sarah Nelson runs a small bike shop in downtown Austin. Her monthly rent runs $2,500, utilities another $500, and her monthly payroll around $10,000. In addition to bikes, components, and other products, Sarah sells bike helmets. Each helmet costs her $40 to buy from her supplier.
One afternoon, a local charity approaches Sarah and offers to buy 200 helmets for $45 per helmet? Should Sarah except their offer? Economist advocate using Marginal Analysis to answer this question. Only those costs directly impacted by this particular transaction should be considered in making her decision. But what about her overhead? If she doesn’t pay her rent and her workers, she can’t sell helmets. And so, those are legitimate costs too, aren’t they? Why wouldn’t they enter into the decision?
To get our mind around this we need to distinguish between variable and fixed costs. Whether she sells 42 helmets or 57 or 109, she still needs to pay around $13,000 a month in overhead. This portion of the cost is fixed. On the other hand, each helmet she sells cost her an additional $40. This portion of her cost is variable. It depends on the sales volume.
The fixed costs must be paid regardless of her decision. And so, they are irrelevant to any particular decision. Here’s the logic. If the transaction covers the variable cost directly attributable to the transaction plus a little, the difference can be applied to those fixed costs. She’s better off than if she doesn’t engage in the transaction. If she tried to incorporate some percentage of these fixed costs into her decision, she might deem this transaction unprofitable and decide against. But this will in the end hurt her overall profitability.
And so, there really are only two relevant pieces of information. How much additional (or marginal) revenue will come in as a result of this decision. And how much will her cost increase specifically because she engages in this transaction. Since she can purchase these particular helmets at $40 a piece, that’s the relevant cost. The Marginal Revenue from the transaction would be $8,400 and the Marginal Cost is $8,000. If she accepts this offer, her profit will be $400 greater than it would be otherwise. And since we’re assuming this won’t cannibalize other potential sales, she should agree to this transaction.
| Marginal Analysis is the comparison of the Marginal Benefits of a decision to the Marginal Costs to that decision to determine whether an affirmative decision will result in a net gain. |
Should Southwest Airlines schedule a second direct daily direct flight between Saint Louis and Portland? It depends. Do they need to lease another plane? If so, this is a relevant Marginal Cost and should be included in the decision. If not, the cost of the plane isn’t relevant and so should be ignored. On the other hand, the additional fuel and maintenance cost is clearly a relevant Marginal Cost. Do they need to hire additional pilots and crew members? If so, relevant. If not, irrelevant. Perhaps they’ll need to pay a landing fee to each airport. Then these are Marginal Cost. In summary, those specific costs that will increase because of this decision are weighed against the anticipated increase in ticket revenue (i.e. Marginal Revenue) from adding that specific additional flight.
Likewise, for personal decisions. Should you stay in college an extra year in order to complete a second major in computer science? What is directly impacted? The marginal costs are the additional tuition and fees plus perhaps the opportunity cost of the foregone salary from delaying your entry into the workforce. But it doesn’t include your rent, food, etc. These you must pay regardless. And so, if the additional earnings are more than sufficient to compensate for the relevant marginal costs, you’re financially better off continuing.