The concept of the margin
Using marginal analysis
In economic theory we assume that economic decisions are taken in a marginal way, which means that decisions to consume (or produce) are made one at a time, taking into account all the relevant information available.
For example, an individual does not generally decide to drink a specific quantity of tea or coffee at the beginning of each day - rather, they make a series of individual decisions, one at a time. The same process also applies to producers, who make decisions on a marginal basis. For example, a firm looking to expand will hire new workers as and when needed, depending on current needs.
Economic decisions are marginal because economic conditions are constantly changing - making decisions 'marginally' is a rational approach to decision making because the 'context' in which a decision is made is rarely constant. Of course, if the context remains exactly the same, then the likelihood is that the same decision will be made.
Economics and marginal concepts
Marginal analysis distinguishes economics from other financial disciplines.
While the idea that choices reflect marginal values dates back to early philosophers, the so-called 'marginal revolution' in economics began in Europe in the 19th century. [i]
Economic analysis is concerned with the impact of small changes in one variable on other variables. This means that while knowing the 'total' value of something is important, it is less useful than knowing the change in value that led to the total.
For example, if a business knows the additional (marginal) cost of supplying a new product and the additional (marginal) revenue from selling that product, it can predict the impact of an increase in production on its profits. In other words, the business does not have to wait for its annual accounts to be produced because the calculation of marginal values provides 'live' data regarding its decisions.
Diminishing marginal utility
The first attempt to understand marginal values and how they affect decision-making was developed came with the law of diminishing marginal utility1 suggests that as more units of a product are consumed the marginal (additional) benefit of each extra unit to the consumer falls, hence consumers are prepared to pay less for these marginal units.
This can be explained as follows:
- Most benefit is generated by the first unit of a good consumed because it satisfies most or all of the immediate need or desire.
- A second unit consumed would generate less utility - perhaps even zero, given that the consumer has less need or less desire. With less benefit derived, the rational consumer is prepared to pay rather less for the second, and subsequent, units, given that the marginal utility falls.
Consider the following figures for utility derived by an individual when consuming bars of chocolate. While total utility continues to rise from extra consumption, the additional (marginal) utility from each bar falls, and becomes negative after 5 bars!
We can show total and marginal utility graphically. While total utility increases, it does do at a declining rate, and eventually starts to turn downwards as the sixth bar of chocolate creates a 'dis-utility'.
The marginal utility falls immediately [and provides the gradient for the total utility curve]. Where total utility is at a maximum, marginal utility is zero.
Marginal utility and the demand curve
If marginal utility is expressed in a monetary form, as more is consumed the expected marginal utility will fall, and the rational consumer will be prepared to pay less. The rational consumer here will pay 15 currency units for the second unit of chocolate, but only 10 units of currency for the third unit of chocolate. The principle of diminishing marginal utility is one way to understand why a demand curve slopes downwards.
While there may be some exceptions, the principle of diminishing marginal utility holds for most goods and services consumed.
Producers - maximising profits
Equally important is the assumption that the owners of firms also try to maximise their self-interest in terms of maximising profits. While this is the starting point for developing an understanding of the behaviour of businesses, there are other objectives which influence business decision making, including the desire to maximise sales or to operate ethically.
These, and other assumptions and axioms form the basis of the economist's approach to the study of rational, self-interested decision making in economic transactions.
Governments - maximising welfare?
The final agent in economics is the government or ‘state’. Government will have a range of objectives depending upon its own political beliefs and the political system that exists, and the current political, economic and social context . It is common to assume that governments in democratic societies wish to maximise the welfare of the citizens who elect them, although cynics might argue differently.
Criticisms
The assumption regarding the maximisation of self-interest has been challenged by ‘behavioural economists’ who question many of these traditional propositions.
Bounded rationality
The idea of bounded rationality questions the assumption of traditional economics that individuals act perfectly rationally when making a decision. The idea of bounded rationality was first proposed by American economist Herbert Simon, who argued that in the real world, individuals typically have limited time in which to make a decision and limited information. Consequently, it is unlikely that they will make accurate assessments of the costs or benefits of a decision. This would simply take too much time and effort, and require skills and abilities that not everyone posses or choose to use. As a result, individuals often make quick decisions and fall-back on ‘rules-of-thumb’ (called heuristics) - especially when faced with complex decisions. This means that decisions may not always result in an optimal outcome.
Many behavioural economists argue that decisions can be shaped in a way that individuals may routinely not act in their own self-interest.
For instance, relying on heuristics can mean that decision making is 'short-circuited' and shaped by certain built-in ‘biases’ for behaving in a certain way, or making a certain decision. This may result in individuals facing an outcome that is ultimately harmful to them, such as over-eating, not saving for retirement, or smoking cigarettes. In addition, decision-making can be shaped by others, so that an individual may suspend their own self-interest as a result of persuasive advertising, ‘smart’ marketing, or imperfect knowledge.
Despite these questions, in building up a theory of economic behaviour we start from the position that consumers and producers are rational in their decision making.
[i] Most notably with the work of English economist, William Stanley Jeavons, Austrian economist Carl Menger, and Swiss economist, Leon Walras (the 'first generation' marginalists) and then developed by Aldred Marshall and other 'second generation' marginalists.
1 The principle of diminishing marginal utility was first proposed by German economist H. Gossen in 1854, and was later refined and developed by a number of economists including British economist Alfred Marshal.