Nov 22, 2017,09:33am EST

Business Planning with Austrian Economics: Marginal Analysis

Bill Conerly
Senior Contributor: Leadership Strategy

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.

SUMMARIZATION:
The Austrian school of economics is an approach to the subject with some distinctive
characteristics that help business leaders find profit opportunities. Like much of economics,
professors tend to be focused either on pure theory or else on public policy implications.
Business applications are the red-headed stepchild of economics.
The article provides a quick summary with the following:
Subjective value is one of the Austrian school’s first important contributions, emphasizing that
the worth of a good or service is based on what people think of it, not some intrinsic
characteristic of the item. Ask not how much it costs to make it; ask how much it is worth to the
customer.

Methodological individualism in business avoids pointing fingers at a group. I wrote about

internal business service problems, The problem, if there is only, is not with a department. It’s
with particular people taking particular actions.

Spontaneous order describes phenomena such as the economy and language as the product of
humans, but not designed by any humans. I advised Your employees do not need everything
planned for them. They can figure a lot of stuff out for themselves, developing better methods
and systems as they go.”
Marginal analysis is how Austrian economists (as well as some others) resolved the diamonds-
water paradox. Water is necessary for life but valued lower than luxuries. The answer is that the
price of water is based upon one additional unit of water. Unless we are dying of thirst in a
desert, most of us are not willing to pay much for one additional glass of water. I determined
how many business decisions are based on average costs rather than marginal costs.

Statistics in Business was prompted by the Austrian school’s disdain for efforts to find
underlying truths through statistical analysis. The wholesale rejection of empirical work by some
Austrian economists is unwarranted. Statistical analysis of past business conditions won’t give a
perfect forecast of future demand, but it’s usually better than guessing.

Reference: https://www.forbes.com/sites/billconerly/2017/11/22/business-planning-with-
austrian-economics-marginal-analysis/#599c09155d24