Marginal Benefit vs. Marginal Cost: An Overview
Marginal benefit and marginal cost are two measures of how the cost or value of a product changes. Marginal benefit impacts the customer, while marginal cost impacts the producer. Companies need to take both concepts into consideration when manufacturing, pricing, and marketing a product.
Marginal benefit is the maximum amount of money a consumer is willing to pay for an additional good or service. The consumer's satisfaction tends to decrease as consumption increases. Marginal cost is the change in cost when an additional unit of a good or service is produced.
- Marginal benefit is the maximum amount a consumer will pay for one additional good or service.
- Marginal benefit generally decreases as consumption increases.
- Marginal cost of production is the change in cost for making one additional good or incremental unit of service.
- The purpose of analyzing marginal cost is to determine at what point an organization can achieve economies of scale.
- Marginal benefit is heavily used in public service as governments must often weigh incremental benefits using limited resources.
Marginal benefit is a small but measurable benefit to a consumer if they use an additional unit of a good or service.
Marginal benefit usually declines as a consumer decides to consume more of a single good. For example, imagine a consumer purchases a ring for her right hand. She spends $100 on the perfect piece of jewelry. Since she does not need two rings, she would be unwilling to spend another $100 on a second ring. She might, however, be convinced to purchase that second ring at $50. For this customer, the marginal benefit of the first ring is $100, while the marginal benefit of the second ring is $50.
Another way to think of marginal benefit is to consider the satisfaction that a consumer gets from each subsequent addition. There are three primary types of marginal benefit:
- Positive Benefit: Marginal benefit increases as additional units are consumed. The popular campaign slogan "Betcha can't eat just one" referred to marginal benefits that may potentially increase after consuming the first potato chip.
- Negative Benefit: Marginal benefit decreases as additional units are consumed. After eating the entire bag of potato chips, a consumer may feel sick and not receive many benefits from eating a second bag. The lessening of appeal for additional consumption is known as diminishing marginal utility.
- Zero/Neutral Benefit: No marginal benefit is gained or lost with each additional unit. The consumer is indifferent to the next potato chip they eat; there is no additional happiness or dissatisfaction gained regardless of the next decision made.
Marginal benefit is often expressed as the dollar amount the consumer is willing to pay for each purchase. It is the motivation behind such deals offered by stores that include "buy one, get one half off" promotions.
Prescription drugs and necessities such as electricity are goods and services that are not subject to the effect of marginal benefits.
Producers must consider marginal cost, the incremental expense to the business if it produces one additional unit. Let's say a company currently manufactures 100 shoes for a total cost of $10,000 ($100/each). It also costs $11,000 to manufacture 120 shoes. The change in total cost ($11,000 - $10,000) divided by the change in units manufactured (120 units - 100 units) yields the marginal cost of the additional 20 shoes ($1,000 / 20 units = $50).
When considering marginal costs, fixed costs are excluded unless the increase in output level pushes the company into a higher relevant range. In the example above, we made the assumption that the company currently had the manufacturing capacity to scale up to 120 shoes. If this is the case, the marginal cost of $50 reflects only variable costs. If the company needs to enter into a new lease to handle the growth, this fixed cost is included in the incremental cost of these additional goods.
If a company captures economies of scale, the cost to produce a product declines as the company produces more of it. Let's say each shoe requires $5 of rubber, thread, and other materials. Each order of materials also costs $25 for shipping and handling. If the company submits an order to make 10 shoes, the cost of the order is $75 (($5 * 10 shoes) + $25 shipping), and the cost per shoe is $7.50. If the company scales and is able to order materials for 30 shoes at one time, the cost of the order is $175 ($5 *30 shoes) + $25 shipping). Due to economies of scale, the cost per shoe is now $5.83.
The most basic profit maximization strategy is to compare a company's marginal revenue and marginal cost. If the company can sell one additional good for more than the cost of that incremental good, the company can increase profit by increasing output.
The concept behind marginal benefit and marginal cost extends beyond business. The relationship between the two also plays an important part in public policy in government. Elected officials must often evaluate and compare the marginal benefit of various public programs when evaluating how to spend money. If crime is high in a specific area, the marginal benefit of additional police resources may outweigh the marginal benefit of increasing transportation subsidies.
Because different initiatives will have different marginal benefits, it is up to elected officials to determine how to allocate limited resources like taxpayer funds. Though it would be possible to completely eliminate specific problems within a city (i.e. 0% crime rate), the marginal benefit of allocating resources to other programs often outweighs the marginal benefit of concentrating on a single issue. For example, let's say the cost to decrease theft from 500 annual cases to 400 annual cases is $100,000. It is up to public officials to determine what it would cost to get the number of annual cases down to 300 and what the benefit would be if these funds were instead spent elsewhere.
Marginal Benefit vs. Marginal Cost Example
Let's say BottleCo, Inc. is a company that manufactures water bottles. Last year, it produced and sold 100,000 water bottles for $600,000. Each water bottle sold for $9. BottleCo is evaluating whether to increase production to 150,000 water bottles.
BottleCo expects to capitalize on some economics of scale by combining raw material orders and leveraging existing equipment capabilities. It expects the total cost to produce 150,000 water bottles to be $825,000. Margin cost per water bottle for these additional 50,000 additional units is $4.50 ($225,000 incremental cost - 50,000 incremental units).
The company also performed market research to better understand what would cause customers to purchase additional water bottles. Expectedly, most consumers stated the law of diminishing returns and didn't have as much incremental marginal benefit for a second water bottle as they did for their first. Therefore, the average customer was only willing to pay $5.50 for an additional water bottle.
Had BottleCo used pricing data from the original 100,000 water bottles manufactured, it would have said it would be unprofitable to make a water bottle for $6.00 and sell it for $5.50. However, the additional 50,000 units take advantage of economies of scale and leverage existing fixed costs. Therefore, the marginal cost to produce the additional water bottles ($4.50/unit) is less than the marginal benefit a customer is expected to receive ($5.500; therefore, it would be profitable to increase production.
How Do You Calculate Marginal Benefit?
Marginal benefit is calculated by dividing the change in total benefit received by the change in the number of units consumed.
Let's say the total value of the benefit received from owning five sweaters is $200. If the total value of the benefit received from owning six sweaters is $220, the marginal benefit of the 6th sweater is $20 (($220 - $200) / (6 sweaters - 5 sweaters)).
How Do You Calculate Marginal Cost?
Marginal cost is calculated by dividing the change in total cost by the change in the number of units produced.
Let's say it costs $100,000 to manufacture 50,000 cell phone cases. If it costs $105,000 to manufacture 55,000 cell phone cases, the marginal cost for the additional 5,000 units is $1/each (($105,000 - $100,000) / (55,000 units - 50,000 units)).
When Does Marginal Benefit Equal Marginal Cost?
When marginal benefit equals marginal cost, market efficiency has been achieved. Producers are manufacturing the exact quantity of goods that consumers want, and no benefit is lost. When this efficiency is not achieved, the number of goods produced should be increased or decreased.