Why does your business need to calculate marginal revenue?
Profit-maximizing firms focus on raising their net earnings and proving their profitability to investors. Therefore, they concentrate on affecting their bottom line with each sale because they usually have stable sales revenue flows. To do this, they need to keep track of their marginal revenue and identify their profit maximization point.
1. Understand the revenue impact of each extra unit sold
Selling extra units of a product or service leads to higher total revenue, marginal revenue, profitability, and additional costs. Therefore, it's essential to understand marginal revenue because it measures revenue increment from selling more products and services.
Marginal revenue is subject to the law of diminishing returns, which states that any production increases will result in smaller increases in output. It means the company has passed its optimal level.
It costs money to produce and sell additional units, and a company will make profits as long as its marginal revenue remains above marginal cost. Past the point where MR equals MC, producing or selling more units makes no sense.
2. Understand the relationship between sales and market demand
Marginal revenue helps companies understand the relationship between sales, market demand, and market competition. Sales correspond to needs, while demand corresponds to wants. Additionally, growth and profitability come from understanding the intricate relationship between the two.
Market demand represents the products and services your customers aspire and are willing to buy, and sales are the products and services they buy.
In a perfectly competitive market, marginal revenue equals the product price at all output levels. Because firms are price takers, they can sell as many products or services as they wish at a given price, and price decreases are not required to spur additional sales.
Other market types such as monopolistic, monopoly, and oligopoly competition will witness decreased marginal revenue with increased production. The reason being they need a price reduction to spur additional sales. As a result, marginal revenue may decrease past zero to become negative.
3. Profit maximization
Since businesses want to maximize profit, they need to keep producing more output so long as each additional unit adds more to the revenue side than the cost side.
The added revenue as marginal revenue, while the added cost is marginal cost. Therefore, companies should continue producing output until the marginal revenue equals marginal cost. Past the profit maximization point (MC = MR), a company cannot make any more profit, and it's in its best interest to stop production.