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What is Marginal Revenue?
In economics and finance, marginal revenue (MR) refers to the additional revenue earned from increasing sales of a product or service by one additional unit. It’s calculated as the total revenue change divided by the quantity of goods sold.
Put simply, it shows how much extra revenue will be gained per unit increased when a company increases its output or number of units sold.
Businesses calculate MR to determine whether investing in future revenue growth by selling additional products is worth it.
It’s important to note that an increase in revenue does not equal an increase in profitability. In most cases, firms must balance maximum profit margins, price optimization, and maximum revenue when analyzing their marginal revenue.
The distinction between average revenue (AR) and marginal revenue is another important distinction. Average revenue is the total amount of money a company earns per unit of output over a certain period of time.
In the short run, MR may be higher than average revenue (AR), meaning the company makes more money per unit sold. In the long run, it will eventually equal the AR.
As prices for a product or service go down due to increased competition, customer demand for that product or service will increase, but AR will remain the same.
- MR: The abbreviated term for “marginal revenue,” often used interchangeably.
Why is Marginal Revenue Important?
MR is an important concept because it helps companies decide whether to increase production and sales or keep prices steady.
It’s also used for revenue optimization, informing business decisions about investing in marketing, production, new feature development, and additional sales efforts.
From the perspective of MR, there are three ways to improve the relationship between each output unit, its price, its respective revenue, and overall profitability.
- Increase prices. To increase the revenue per unit sold while maintaining sustainable growth, the demand should exceed the supply or price elasticity should be low. At the very least, a decrease in demand shouldn’t outpace the price increase.
- Reduce marginal costs. Lowering delivery or production costs per unit sold allows companies to remain competitive while still making a profit. When a company becomes more efficient, it can improve its profitability without changing its marginal revenue.
- Maximize output. Businesses can maximize total revenue generation by producing and selling the most units possible within a given time frame. Since this usually involves discounting or lowering the price altogether, it usually occurs at the expense of marginal revenue. The additional units sold must make up for the lower revenue per unit.
Organizations can reasonably determine what growth strategies are most feasible by calculating marginal revenue and applying it to the bigger-picture profitability equation.
How to Calculate Marginal Revenue
Marginal Revenue Equation
In its most basic sense, the marginal revenue equation shows that when revenue increases, the number of units sold must increase. MR is calculated as the change in total revenue (TR) divided by the change in quantity (Q).
The marginal revenue formula is as follows:
MR = (change in TR) / (change in Q)
To effectively calculate MR:
- Calculate the change in total revenue (TR) by subtracting the original TR from the new TR.
- Determine the change in quantity (Q) by subtracting the original Q from the new Q.
- Divide the change in total revenue by the change in quantity to find MR.
Marginal Revenue Calculator Example
Imagine a company sells widgets for $5 each. The company sold 10 widgets for a total of $50. The company does not operate in a competitive market, and the demand for the good is inelastic (doesn’t change much with price).
The company decides to lower the sale price of a widget from $5 to $4 to see if it would increase sales metrics. To calculate MR, first, we must find the change in total revenue:
- Change in TR = new TR – original TR
- Change in TR = ($40) – ($50)
- Change in TR = -$10
Next, calculate the change in quantity:
- Change in Q = new Q – original Q
- Change in Q = (15) – (10)
- Change in Q = 5
Finally, divide the change in total revenue by the change in quantity to determine MR:
- MR = (-$10 / 5)
- MR = -$2
In this example, the marginal revenue for each additional widget sold is -$2. This means that for every additional widget the company sells, it generates $2 less in revenue than before.
Since the demand doesn’t change much with changes in the selling price, it wouldn’t make sense for the company to alter its pricing strategy to incentivize more sales.
The Relationship Between Marginal Revenue and Marginal Cost
Marginal revenue and marginal cost both play an important role in determining profitability, but the two are not directly related.
The Difference Between Marginal Revenue and Marginal Cost
Marginal cost is the variable cost incurred by a business for producing and selling one additional unit of output. It’s calculated by dividing the incremental change in total cost by the change in quantity.
Marginal cost is based on the variable and fixed costs associated with the level of output. When output increases, marginal cost sometimes increases.
At some point, economies of scale kick in, and marginal cost starts to decrease.
Marginal revenue doesn’t consider costs—it’s based solely on changes in sales prices, product quantities, and total revenue.
To get a complete picture of whether or not selling an additional unit is viable, businesses need to know their marginal profit, which is calculated by subtracting marginal cost from marginal revenue.
Marginal profit can vary widely depending on the industry and context. In any case, when a business’s marginal profit is negative, it should consider cutting prices or ceasing production of that particular unit to reduce costs and increase profitability.
The Marginal Revenue Curve
The marginal revenue curve is a graphical representation of marginal revenue. It provides visual evidence of what happens to total revenue when additional units are sold at a given price.
The shape of the curve can vary depending on the type of market structure, but it is typically downward-sloping—that is, it shows that as more units are sold, MR starts to decline because the company is forced to decrease prices to keep up with demand.
For this reason, companies usually need to decrease their product price to increase their market share. The idea behind the marginal revenue curve is that at some point, the market price for a product will be so low that producing more units of it will no longer make sense from a business perspective.
Examples of Marginal Revenue
Although MR seems straightforward (i.e., “Unit X sells for $Y, so we can expect a $Y increase in revenue”), interpreting it to calculate profitability is a bit more complicated because the price per unit isn’t always the same.
For example, if Company A sells 10 units at $10 each and then decides to sell 11 units to a customer (i.e., buy 10, get one free), the marginal revenue would be lower than if they sold 11 units at $10 each.
Since they would need to lower the proportional price to sell more units, this would decrease the marginal revenue.
Now, suppose Company A finds a customer segment that really needs its product and is willing to pay $15 per unit.
In this case, the company would make more money by selling fewer units at a higher price—their marginal revenue for each additional unit sold would be $15 instead of $10.
Should the company keep prices steady, raise them to meet the demand at the higher price, or lower them to generate higher overall revenue?
The answer depends on the MR curve, which illustrates the change in revenue when output is increased.
Companies can identify the strategy that yields the most additional profits by plotting marginal revenue against additional output and optimize their production level accordingly.
People Also Ask
Is marginal revenue the same as profit?
Marginal revenue and profit are not the same. Profit describes the net gain or loss associated with a business operation, taking into account revenue and operational costs. Marginal revenue only shows the increase in total revenue that occurs when one additional unit is sold. In order to calculate additional profits from an increase in marginal revenue, businesses must also account for the marginal cost of the product, which is the cost associated with producing one additional unit.
Can marginal revenue be negative?
Marginal revenue can be negative, and it often is. When units of output sold are priced at a lower rate than the average price of all units sold, marginal revenue falls. This can occur when businesses offer discounts or other incentives to customers to increase sales.
Negative marginal revenue is not necessarily a bad thing—sometimes, it is nothing more than a factor of production and demand. As shown by the marginal revenue curve, businesses often need to lower their prices to keep up with market demand. Unless there is a proportional increase in production efficiency, the marginal revenue figure will decrease.
What is the difference between average revenue and marginal revenue?
Average revenue describes the total revenue generated from a product divided by the number of units sold. Marginal revenue describes the change in total revenue that occurs when one additional unit of that product is sold.
Average revenue typically remains steady regardless of output level, while marginal revenue changes as more units are produced and sold.
There may be times where marginal revenue is higher or lower than the average revenue, depending on sales incentives, volume discounts, and changes in production levels.