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Marginal revenue is the additional revenue a business can expect to generate when selling one more unit of a product or service. Calculating marginal revenue helps merchants determine the monetary benefits of producing a higher quantity of products and ultimately decide if additional units should be created and sold or if it’s better to stop production. In this post, we’ll explain everything you need to know about marginal revenue and how to calculate it using the marginal revenue equation.
Here’s what we’ll cover:
- What is marginal revenue?
- How to apply it in business?
- Marginal revenue and other economic metrics
- What is the marginal revenue formula?
- How to calculate marginal revenue?
- How to calculate marginal revenue from a table?
- What are the benefits of the Marginal Revenue?
- Marginal revenue calculator
What is marginal revenue?
Before we get into marginal revenue, it’s essential to take a step back and talk about a challenge every business faces when it comes to pricing. Logic would have it that sales will increase if your business charges a lower price for its products. On the other hand, if you charge customers to pay higher prices, you’ll probably sell fewer products but make more profit from each sale. However, as a business owner, this is where things get a little more complicated. How can you know if the amount you gain by charging higher prices and raising your profits offsets the losses you sustain by selling fewer products?
That’s where marginal revenue comes in.
Marginal revenue definition
Marginal revenue refers to the increase in revenue that results from a one-unit increase in production. Calculating marginal revenue helps businesses determine whether or not additional production costs outweigh the benefit of selling more units and also helps to analyze consumer’s demand. Ultimately, to remain profitable, your business needs to keep marginal revenue higher than the marginal cost of production.
How to apply it in business?
There are several key ways to apply marginal revenue in business. These include:
Profit maximization
As a business owner, profit maximization is your number one goal. Maximizing profits requires producing and selling more products or services where each additional unit adds more marginal revenues than marginal costs. When marginal revenue equals marginal cost, profit has reached its maximum, so you should cease production as you will not make any more profits and eventually lose money.
Revenue impacts & Revenue optimization
Selling additional units of a product or service leads to higher total revenue, marginal revenue, and costs. By calculating marginal revenue, you can understand the revenue and profit increments from selling more products and services by calculating marginal revenue. You can also understand when the cost of producing and selling additional units becomes no longer worth it and optimize revenue via your payment methods and analytics performed.
Understanding the link between sales & demand
Calculating marginal revenue helps you to better understand the link between your sales and economic demand. Sales show the actual products and services purchased by customers. Demand represents the products and services customers want and are willing to buy.
In a perfectly competitive market, businesses can sell as many products or services as they want at their chosen price. Price decreases are not required to boost further sales. In contrast, businesses experience decreased marginal revenue with increased production in monopolistic markets because price reductions are needed to drive additional sales. This can lead to marginal revenue becoming negative.
Marginal revenue and other economic metrics
Economic theory states that perfectly competitive companies in a market with no monopolies (perfect competition model) will keep producing goods or services until marginal revenue is equal to marginal cost. So, even though marginal revenue can remain constant at a specific output level for some time, according to the law of diminishing returns, it will decline eventually as the output increases.
Now that we've briefly covered the theory, let’s look at some other important economic terms related to revenues and costs and see how they correlate with each other.
Marginal Revenue vs. Average Revenue
Marginal revenue equals or measures the relationship between the change in total revenues and the change in quantity. On the other hand, average revenue simply refers to the average price paid for one unit sold of a product or service. It is calculated by dividing total revenue by the quantity sold. Ultimately, average revenue is best when you need to determine prices, while marginal revenue is all about price optimization.
Marginal Revenue vs. Total Revenue
Marginal and total revenue are different but directly related. While marginal revenue measures the total revenue earned by selling an additional output unit (additional sale), total revenue is the total amount of revenue earned by a business. Total Revenue is calculated by multiplying the price of a product or service times the quantity sold. Tracking total revenue is critical because it enables a business to assess growth. It also provides insights into what parts of a company are working and which parts aren’t. Furthermore, understanding total revenue makes it possible to produce better forecasts and more accurate budgets for expenses.
Marginal Revenue vs. Marginal Cost
Marginal revenue refers to the revenue a business earns by selling an additional unit of output. In contrast, marginal cost is the change in total production cost when producing or supplying one more unit of a good or service. If marginal revenue exceeds marginal cost, that’s a sign you should sell more products. The opposite is also true. If marginal costs are higher than revenues, you should not produce and sell more units because you’ll lose money.
Marginal Revenue Curve vs. Demand Curve
Marginal revenue curve is a graph that represents the relationship between the marginal revenue earned and the products sold. Marginal revenue is mostly illustrated alongside a demand curve. The demand curve shows the changes in the quantity of an item that consumers are willing and able to buy as it changes in price. The steeper the demand curve is, the more a producer needs to lower the price to increase the amount buyers are willing and able to buy and vice versa. Understanding the demand curve is important because it illustrates how much a business has to lower its price to sell an additional good or service.
Marginal Revenue and Average Revenue Curves
The demand curve graph represents the relationship between the price of a product or service and the quantity demanded. The steeper the demand curve is, the more a business needs to lower the price to increase the amount buyers are willing and able to buy and vice versa. As you can see on the graph below, the price is on the vertical axis, and the quantity demanded is on the horizontal axis. The marginal revenue curve is a horizontal line at the market price, implying perfectly elastic demand and is equal to the demand curve.
Understanding the demand curve is important because it illustrates how many units of a good or service will be purchased at different prices.
What is the marginal revenue formula?
To calculate marginal revenue, all you need to do is divide the change in total revenue by the change in its total output quantity sold. The selling price of a single additional item sold is the marginal revenue.
Marginal Revenue equation = Change in Revenue / Change in Quantity Sold
Here is a marginal revenue example: Business A makes 100 couches and sells them for $500 per unit to get $50,000 in revenue. To sell more than 100 couches, the company works out that it needs to reduce the price of each couch to $499. In this case, the marginal revenue will equal:
$50,399 ($499x101) – $50,000 ($500x100)/ 1 (101 - 100) = $399
Let’s take a look at another quick example. A business increases the production of a product by 100 units and receives $500 in revenue. Marginal revenue will equal: 500 (change in revenue)/100 units (change in quantity) = $5
How to calculate marginal revenue?
To work out the marginal revenue of a product or service, follow the steps below:
Calculate the total revenue
The first step in calculating marginal revenue is to find the total revenue. To calculate total revenue, you can use the following formula:
Current price x current sales = total revenue
Note: when there is positive marginal revenue, total revenue is increasing.
Perform a market analysis
The next step after determining the total revenue is to perform a market analysis & analyze consumer demand. A market analysis involves collecting data and getting a better understanding of the impact of a lower price point and changing the number of units produced. When conducting a market analysis, it’s important to study your competitors' pricing and be prepared to adjust your prices lower depending on what you discover.
Calculate the alt revenue
Now that you’ve done your market analysis, it’s time to calculate alternative revenue using the numbers you derived from your market research. To calculate alternative revenue, all you need to do is multiply the alternate price by the alternate number of products sold.
Net marginal revenue
To calculate marginal revenue, all you need to do is divide the change in total revenue by the change in its total output quantity sold. The selling price of a single additional item sold is the marginal revenue.
Marginal Revenue = Change in Revenue / Change in Quantity Sold
Apply the marginal cost equation
To calculate your product's marginal cost (the cost added by producing one additional unit of a product), use the following equation:
([Alternate revenue] - [total revenue]) / ([alternate sales] - [current sales])
Marginal curve and marginal cost
Marginal revenue usually sits below the demand curve. It is related to the percentage change in quantity demanded of a product to the percentage change in price (price elasticity of demand). Demand is elastic when marginal revenue is positive and inelastic when marginal revenue is negative.
Analyze the data
Once you've figured out the marginal revenue for one of your products or services, it’s simply a matter of repeating the same process for your other products. You can use the data to optimize the balance between the price of your product and the number of sales.
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Marginal revenue in economics and how to calculate it?
Marginal revenue refers to the increase in revenue that results from a one-unit increase in production. Calculating marginal revenue helps businesses determine whether or not additional costs outweigh the benefit of selling more units. Ultimately, to remain profitable, your business needs to keep marginal revenue higher than the marginal cost of production.
To calculate marginal revenue, simply divide the change in total revenue by the change in its total output quantity sold. The selling price of a single additional item sold is the marginal revenue.
Marginal Revenue = Change in Revenue / Change in Quantity Sold
How to calculate marginal revenue from a table?
Let’s take a look at an example using the table below to illustrate how total and marginal revenue are calculated. In this case, a fictional business that sells t-shirts. Marginal Revenue = Change in Revenue / Change in Quantity Sold:
As you can see, the marginal revenue fluctuates. For example, if the business reduces the price from $7 to $6, and quantity increases to 5, total revenue increases by $2, and marginal revenue is $2. If the business drops the price from $3 to $2, total revenue decreases by $6. The marginal revenue diminishes to $-6.
What are the benefits of the marginal revenue?
There are many ways to operate a business, but the end goal is always to make as much as possible. Ultimately, understanding marginal revenue and marginal costs are critical to your business’ success because they help you to determine how much of an additional product or produce output should be made. You can gain an in-depth understanding of your exact revenues, profit increments and your profit maximization point made from selling more products and services. In addition, you can also more accurately plan production schedules and better understand the link between your sales and economic demand.
Marginal revenue calculator
Having a marginal revenue calculator at your disposal can help speed up your calculations. Each company calculates marginal revenue and can do that by gaining access to a free calculator here.
