Key Takeaways
- Marginal revenue refers to the incremental change in earnings resulting from the sale of one additional unit.
- Analyzing marginal revenue helps a company identify the revenue generated from each additional unit sold.
- Marginal revenue is graphically shown as a downward-sloping line representing how a company usually has to decrease its prices to drive additional sales.
- A company looking to maximize its profits will produce up to the point where marginal cost equals marginal revenue.
- When marginal revenue falls below marginal cost, firms conduct a cost-benefit analysis and halt production as it may cost more to sell a unit than the company will receive in revenue.
Understanding Marginal Revenue
Marginal revenue is a financial and economic calculation that determines how much revenue a company earns for each additional unit sold. As the price of a good is often tied to market supply and demand, a company’s marginal revenue often varies based on how many units it has already sold.
Marginal revenue is useful in several contexts. Companies use historical marginal revenue data to analyze customer demand for products in the market. They also use the information to set the most effective and efficient prices. Lastly, companies rely on marginal revenue to better understand forecasts; this information is used to determine future production schedules.
How to Calculate Marginal Revenue
A company calculates marginal revenue by dividing the change in total revenue by the change in total output quantity. Ideally, the change in measurements captures the change from a single quantity to the next available quantity. However, the formula can still be used to capture average marginal revenue across a series of units.
The formula for marginal revenue is:
Marginal Revenue = (Change in Revenue) / (Change in Quantity)
MR = ΔTR / ΔQ
For example, imagine a company sold its first 100 items in one week for a total of $1,000. Marginal revenue disregards the previous average price of $10 as it only analyzes the incremental change. If it sold a total of 115 units for $1,100 the next week, the marginal revenue for units 101 through 115 is $100, or $6.67 per unit ($100 ÷ 15).
Marginal Revenue Curve
Marginal revenue can be graphically depicted and is often represented as a downward-sloping straight line on a chart capturing price on the y-axis and quantity on the x-axis.
The marginal revenue curve is often downward sloping because there is often an economically inverse relationship between price and quantity. As a company decreases the price of its product, more units will likely be demanded; as the price increases, demand often decreases.
Average Revenue Curve
Marginal revenue can be analyzed by comparing marginal revenue at varying units against average revenue. Average revenue is simply the total amount of revenue received divided by the total quantity of goods sold.
In perfect competition, marginal revenue is often equal to average revenue. This is because collective market forces make each participant a price-taker. However, in imperfect competition, marginal revenue and average revenue will vary.
Example of Marginal Revenue
To assist with calculating marginal revenue, a revenue schedule outlines the total revenue earned, as well as the incremental revenue for each unit. The first column of a revenue schedule lists the projected quantities demanded in increasing order, and the second column lists the corresponding market price. The product of these two columns results in projected total revenues in column three.
| Demand Projection | Projected Market Price | Projected Revenues |
|---|---|---|
| 10 | $9.00 | $90.00 |
| 11 | $8.50 | $93.50 |
| 12 | $8.25 | $99.00 |
| 13 | $8.12 | $105.56 |
| 14 | $8.00 | $112.00 |
Marginal Revenue vs. Marginal Cost
Any benefits gained from adding an additional unit of activity are marginal benefits. One such benefit occurs when marginal revenue exceeds marginal cost, resulting in a profit from new items sold.
A company experiences the best results when production and sales continue until marginal revenue equals marginal cost. Beyond that point, the cost of producing an additional unit will exceed the revenue generated.
Competitive Firms vs. Monopolies
Marginal revenue for competitive firms is typically constant because the market dictates the optimal price level. Marginal revenue works differently for monopolies. For a monopolist, the marginal benefit of selling an additional unit is less than the market price.
Is Marginal Revenue the Same As Profit?
Marginal revenue only considers income received and does not reflect any marginal expenses required to manufacture or sell the goods. Therefore, marginal revenue is different from profit.
Conclusion
Regardless of its sector, industry, or product line, companies must be aware of how increasing sales quantities impact marginal revenue. If the company must decrease prices to generate additional sales, marginal revenue will slowly decrease to the point where it is no longer profitable to sell additional goods.
Related Terms: marginal cost, total revenue, average revenue, market price, demand.
