Learn how to calculate marginal revenue, why it is important for business, and what the real world application of this concept is.
Marginal revenue is one of many ways you can analyze revenue data to uncover helpful insights for investors and businesses. It has a variety of financial and managerial accounting applications. Management, for instance, can use it to understand consumer demand, plan production schedules, and set product prices. Let's take a closer look at the concept of marginal revenue and how you could make use.
What is marginal revenue?
Marginal revenue (MR) is an economic concept used in business to optimize profits. Marginal revenue is the revenue generated for each additional unit sold relative to marginal cost (MC). This is useful for businesses to balance their production output with their costs to maximize profit.
Since marginal revenue is subject to the law of diminishing returns, it will eventually slow down with an increase in output level.
Both large and small businesses can examine their marginal revenue to determine their level of earnings based on extra output units sold. Hence, companies seeking to maximize profits must increase their production until marginal revenue equals marginal cost (MR=MC). On the other hand, businesses may decide to cease production when marginal revenue is less than marginal cost.
Economic theory states that perfectly competitive firms will continue to produce output until marginal revenue equals marginal cost.
Marginal revenue and other economic metrics
Economic theory assumes that perfectly competitive firms will continue producing output to increase profits until marginal revenue equals marginal cost. Below is the relationship between marginal revenue and other economic metrics:
1. Marginal revenue vs. average revenue
Marginal revenue is the net revenue a business earns by selling an additional unit of its product. It is the additional revenue from selling one more unit. On the other hand, average revenue refers to revenue earned per output unit. To obtain average revenue, divide the total revenue earned from the number of units sold.
A competitive firm's price equals its marginal revenue and average revenue because it remains constant over other varying output levels. However, marginal revenue diminishes with each additional unit sold for a monopoly, and it's always equal to or less than its average revenue—the reason being that price changes with the change in quantity sold.
2. Marginal revenue vs. total revenue
As stated above, marginal revenue is the revenue increment from selling an additional unit of a product. In contrast, total revenue refers to the full amount of total product sales regardless of revenue source: sales, investments, marketing, and customer success. To calculate total revenue, multiply the number of goods or amount of services sold by their prices.
Marginal revenue directly relates to total revenue because it measures the total revenue increase from selling an additional product unit.
3. Marginal revenue vs. marginal cost
Marginal revenue refers to the money a company makes from each additional sale, while marginal cost is the amount it costs the company to produce extra units. When marginal revenue is higher than a firm's marginal cost, then it is making money.
When marginal costs equal marginal revenue, then the firm enjoys profit maximization. Past this point, the company cannot make any more profit since any additional production costs more.
4. Marginal revenue curve vs. the demand curve
Marginal revenue is usually below the demand curve. It's related to demand's price elasticity—the responsiveness of quantity demanded to a price change. Thus:
- Demand is elastic when marginal revenue is positive
- Demand is inelastic when marginal revenue is negative
- Demand is unitary elastic at the point where marginal revenue equals zero
How to calculate marginal revenue
Marginal revenue equals the sale price of an additional item sold. To calculate the marginal revenue, a company divides the change in its total revenue by the change of its total output quantity. Marginal revenue is equal to the selling price of a single additional item that was sold.
Here's the marginal revenue formula:
Marginal revenue = Change in revenue / Change in quantity
To calculate the revenue change, the company subtracts the revenue figure achieved before the sale of the last unit from the total revenue received after the sale.
You can use the above marginal revenue formula to measure any production level change. Typically, businesses use it to measure the change in the production of an additional unit, so the denominator generally is one (1).
3 examples of marginal revenue
Below are three practical approach examples of how to calculate marginal revenue:
Example one: Say a company increases its production of product X by 100 units and receives $200 in revenue. Marginal revenue will be:
$200 (change in revenue)/ 100 units (change in quantity) = $2 (marginal revenue)
Example two: A company usually sells 40 products for $600 but decides to make an additional sale at $8. Marginal revenue will be $8, and you will ignore the average price of $15 ($600/40) since MR is only concerned with the incremental change or the additional item sold:
$8 (change in revenue)/ 1(change in quantity) = $8
Example three: Company Z produces 100 desks and sells them for $150 per unit to get $15,000 in revenue. The company then realizes it will need to drop its desk price to $149 per desk to produce and sell over 100 units. The marginal revenue will be:
$15,049 ($149*101) – $15,000 ($150*100)/ 1 (101 - 100) = $49
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.
Marginal revenue FAQs
Marginal revenue vs. average revenue: What is the difference?
Marginal revenue is the net revenue a business earns by selling an additional unit of its product, while average revenue refers to revenue earned per output unit. Thus, marginal revenue is the change in revenue divide by the change in quantity, while average revenue is total revenue divided by the number of units sold.
What is marginal revenue used for?
Analyzing marginal revenue helps companies identify the revenue generated from selling an additional unit of production. Therefore, they can use marginal revenue to raise output to the profit maximization point.
How is marginal revenue used in cost analysis?
Rational companies always seek to make as much profit as possible. Understanding the relationship between the marginal cost of production and marginal revenue helps them identify the point where this occurs. The target is the profit maximization point where marginal revenue equals marginal cost.
How are marginal revenue and the demand curve related?
Marginal revenue is typically below the demand curve and is related to demand's price elasticity— quantity demanded's response to price changes. Therefore, a positive marginal revenue corresponds to elastic demand, while a negative marginal revenue corresponds to inelastic demand.