What is Marginal Revenue (MR)?

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Definition:

Marginal revenue is the increase in a company’s revenue for each additional unit of a product that the company sells.

🤔 Understanding marginal revenue

When a company sells a product or a service, it earns revenue (income generated through sales and other business operations). The additional revenue a company makes by selling an extra unit of a product or service is the marginal revenue of the sale. Often the marginal revenue for selling a good is constant as each sale produces the same amount of revenue whether it’s the first unit sold or the millionth. However, in many cases, the law of diminishing returns kicks in and marginal revenue decreases as output increases (as the corporation needs to offer sales or bulk discounts to move additional units of product). Theoretically, businesses should increase production until marginal revenue equals the marginal cost of production, maximizing profit.

Takeaway

Marginal revenue is like eating food…

People need to eat to get required nutrients and calories. Eating can be enjoyable when you eat things that taste good. As you start to eat more, you start to get less value from the food because you’re already full or your body can’t process the additional nutrients quickly enough. The marginal benefit of each piece of food drops. Marginal revenue is similar. You get value from each item you sell, but the value might drop the more you sell.

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What is marginal revenue (MR)?

Marginal revenue is the increase in revenue that a company receives when it sells one more unit of a product or service. Put another way, the revenue generated by a business’s most recent sale of a product is the marginal revenue of that product. For example, a bar that sold two sodas, both at $4, has a marginal revenue of $4 for soda. If the first soda sold for $5 and the second for $3, the marginal revenue is $3, even though the total revenue is the same.

Marginal revenue tends to remain the same at many levels of a business’s output because the company will tend to sell the same product or service at the same price. However, the law of diminishing returns dictates that marginal revenue eventually decreases for each additional unit sold. For example, if a company sells enough of a product to meet consumer desire, it would need to decrease prices to increase demand.

In theory, companies continue to produce and sell things until their marginal revenue equals or drops below the marginal cost of producing them. This lets the business maximize profits from sales.

How does marginal revenue work?

Marginal revenue works by measuring the additional revenue that each additional sale of a product produces.

You can represent marginal revenue on a chart, similar to the law of supply and demand. Typically, marginal revenue is relatively steady, but at some point, it begins to drop.

On a graph of supply and demand curves, the marginal revenue curve will show up below the demand curve. Once a company satisfies its customers’ demand, it must decrease the price of its product to produce additional demand and sales. As the company decreases the price, the revenue produced by each additional sale is lower than the revenue produced by each previous sale.

Taken to an extreme, the marginal revenue for a product approaches zero as the company decreases the price to zero to maximize demand. In reality, companies will stop reducing prices when they begin losing money on each sale. That means that marginal revenue typically stays at or above marginal cost of production.

How do you calculate marginal revenue?

You can calculate marginal revenue by using a table containing sale information or from demand information.

From a table

Consider a table that has information about each sale of a product, such as:

Unit NumberTotal RevenueSale Price
1$5$5
2$10$5
3$15$5
4$19$4
5$21$2

To find the marginal revenue of each you need to find its sale price. To do this, subtract the total revenue after its sale from the total revenue after the sale of the previous unit.

For example, the total revenue after the third sale was $15. The total revenue after the second sale was $10, which means the marginal revenue produced by the third sale was:

$15 – $10 = $5

After the fifth sale, the total revenue was $21, compared to $19 after the fourth sale, so the marginal revenue of the fifth unit produces was:

$21 – $19 = $2

From demand

Marginal revenue is related to the price of each unit sold, which relates to demand for the product. You can use demand to find the price of a product using the Inverse demand equation.

X + (Y quantity demanded) = Price*

Where X is the lowest price at which there is no demand, and Y is the slope of the demand curve.

For example, if a company selling erasers knows that at $5, there is no demand for its product and that the slope of its demand curve is -.02, then it can calculate marginal revenue for each unit sold.

At 100 units, the price (or marginal revenue for the sale) is:

$5 + (-.02 100) = $3*

What is the marginal revenue curve?

The marginal revenue curve is a graphical representation of the change in marginal revenue as the demand for a product changes.

To produce additional demand for a good or service, the company must reduce that product’s price. Because of this, the marginal revenue curve falls below the demand curve on the chart. As demand increases, marginal revenue drops because prices must decrease for demand to rise.

What is the formula for marginal revenue?

The formula for calculating marginal revenue is:

Change in total revenue / change in quantity sold = Marginal revenue

If quantity sold increases by one and total revenue rises by $20, then marginal revenue for that sale was:

$20 / 1 = $20

If revenue rises by $80 after five sales, the marginal revenue for those sales was:

$80 / 5 = $16

What is marginal cost?

Marginal cost is the price of producing one more unit of a service or a product. For example, if it costs $100 to produce 100 pencils and $101 to produce 101 pencils the marginal cost of producing the additional pencil is $1.

In theory, businesses continue to produce and sell products until the marginal revenue from each sale falls below the marginal cost of producing and selling the item, meaning the profit margin is zero. This lets the company maximize profits and avoid selling products at a loss.

Like marginal revenue, which typically drops as sales increase, marginal costs tend to drop as a company makes more of a product. This is largely caused by economies of scale.

Consider a company producing lumber used for construction. It may cost $50 per log for the first 100 logs purchased, but drop to $49 logs if the company buys more than 100, then $48 if the company buys more than 1,000, and so on.

As the company makes more lumber, the cost of making each plank decreases.

Eventually, marginal costs tend to increase as economies of scale become less efficient, and the marginal return from each input drops. For example, the lumber company may save money by purchasing huge quantities of logs, but eventually the increased storage costs for logs awaiting production outpace the savings from buying in bulk.

How do you calculate marginal cost?

The formula for marginal cost is:

Change in cost / Change in quantity produced = Marginal cost

For example, if it costs $100,000 to make 10 cars, and $109,000 to make 11 cars, the marginal cost of the eleventh car is:

($109,000 – $100,000) / (11 – 10) = $9,000

If it costs $100,000 to make 10 cars and $140,000 to make 16 cars, the marginal cost of those cars is:

($140,000 – $100,000) / (16 – 10) = $6,666.67

As long as the marginal revenue of each sale is higher than the marginal cost, the company’s net income will increase.

What is average revenue?

Average revenue is the average amount of revenue that a company produces from each sale of a product. The formula for average revenue is:

Gross income from sales / quantity sold = average revenue

If a company sells 1,000 televisions, earning $500,000, the average revenue from each sale is:

$500,000 / 1,000 = $500

This does not mean the company sold every television for $500. It may have sold half of them for $600 and half for $400. It only shows the average revenue from each sale that the company made.

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