What is the marginal revenue formula?

What is marginal revenue?

Marginal revenue refers to the additional income a business earns by selling one more unit of a product or service. It represents the incremental change in total revenue generated from an additional unit sold. Understanding marginal revenue helps businesses optimize their pricing and output levels to maximize profits in both competitive markets and monopolistic settings. 

How to calculate marginal revenue

To calculate marginal revenue, use the formula:

Marginal Revenue (MR) = Change in Total Revenue ÷ Change in Quantity Sold

This formula shows the revenue change that occurs due to an incremental change in the production level. For example, if selling an additional unit of output increases total revenue by $100, the marginal revenue is $100. 

There are a few key steps when calculating marginal revenue:

1. Determine the total revenue before and after the sale of the additional unit.
2. Subtract the total revenue before the change from the total revenue after the change.
3. Divide the result by the number of additional units sold.

Why does your business need to calculate marginal revenue?

Calculating marginal revenue helps businesses make informed decisions about pricing, production, and resource allocation. It’s often displayed as a graph, and it’s usually a downward-sloping curve. This represents how companies usually have to decrease their prices in order to gain additional sales as time goes on. 

Marginal revenue directly impacts the following areas:

• Profit maximization: To  maximize profits, companies will produce more units until marginal cost equals marginal revenue.
• Pricing strategies: Understanding the relationship between selling price, demand, and revenue helps businesses adjust their average price to gain a competitive advantage.
• Forecasting and modeling: Analyzing financial statements and revenue trends allows businesses to predict revenue changes and strategize accordingly.
• Resource management: Calculating marginal revenue can help identify diminishing returns and avoid overproduction, which could lead to inefficiencies. When marginal revenue drops below  marginal cost, businesses often halt production and run a cost-benefit analysis, because the cost to produce a unit may be more than the revenue it generates.

Example of marginal revenue

Company A sells a product for a fixed selling price of $50 in a competitive market. Initially, it sold 100 units, earning a total revenue of $5,000. After increasing production to 101 units, the total revenue becomes $5,045.

Calculation:

• Change in total revenue: $5,045 - $5,000 = $45
• Change in quantity sold: 101 - 100 = 1 unit
• Marginal revenue: $45 ÷ 1 = $45

This example illustrates that the marginal revenue ($45) for producing and selling one additional unit of output is slightly less than the selling price due to additional costs or potential pricing adjustments due to changes in demand. This shows how important it is for businesses to balance revenue gains against total cost to maintain a healthy profit margin.

What is the marginal revenue curve?

The marginal revenue curve is a graphical representation of how marginal revenue changes as a company increases its output. It shows the relationship between the quantity of goods sold and the additional revenue generated per unit. In most cases, the marginal revenue curve slopes downward, reflecting diminishing returns as output increases and consumer demand adjusts.

For businesses operating under perfect competition, the marginal revenue curve is typically a horizontal line, because product price remains constant regardless of the quantity sold. However, in markets where a business has pricing power, the marginal revenue curve is downward-sloping, illustrating that additional units can only be sold at lower price points to meet consumer demand. 

This often leads to a point where marginal revenue decreases and intersects with the cost curve, guiding decisions about optimal production levels.

Average revenue curve

The average revenue curve is calculated by dividing total revenue received by the total quantity of goods sold. It illustrates the revenue earned per unit of output at different levels of production. In perfectly competitive markets, the average revenue curve coincides with the marginal revenue curve because the product price remains constant. In markets with differentiated products, the average revenue curve is downward-sloping, reflecting the relationship between price and consumer demand.

For example:

• In a perfectly competitive market, the average revenue curve is a flat line at the price point.
• In other markets, the average revenue curve reflects how revenue decreases as the company lowers prices to sell additional units.

The interaction between the marginal revenue curve and the average revenue curve helps businesses understand their pricing strategies and determine when additional production becomes unprofitable. The curves intersect at key points that indicate whether a company is operating efficiently in terms of price and output.

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Marginal revenue vs. other economic metrics

Marginal revenue is closely related to several other key economic metrics that businesses often use to track and evaluate their performance, profitability, and efficiency. Understanding how marginal revenue compares to metrics like marginal cost, average revenue, and total revenue can provide insights into pricing strategies, production levels, and market dynamics. These comparisons help businesses optimize their operations in response to microeconomic factors like supply, demand, and price sensitivity.

Marginal revenue vs. marginal cost

Marginal revenue and marginal cost are useful metrics for determining optimal production levels. While marginal revenue measures the additional income earned from selling one additional unit of a product, marginal cost measures the additional expense incurred from producing that unit. A firm achieves marginal profit when marginal revenue exceeds marginal cost, while losses occur when the reverse is true.

For example, if a company’s marginal revenue from selling an additional item is $20, but its marginal cost is $15, the company gains $5 in profit. However, if additional production increases marginal costs above marginal revenue, production should be scaled back to maintain profitability.

Marginal revenue vs. average revenue

While marginal revenue reflects the income from making one additional sale, average revenue calculates the total revenue divided by the number of units sold. In perfectly competitive markets, average revenue equals the market price, and both the marginal revenue and average revenue curves align horizontally.

In markets where companies have pricing power, marginal revenue often falls below average revenue as prices decrease to sell additional units. This difference highlights how price sensitivity and price changes affect overall revenue.

Marginal revenue vs. total revenue

Marginal revenue represents the change in total revenue for each additional item sold, while total revenue measures the cumulative earnings from all sales. For example, if a company’s total revenue is $10,000 and increases to $10,200 after selling 10 more items, the marginal revenue per item is $20.

As production increases, the relationship between these metrics can reveal important trends. For example, in some markets, revenue increases initially as production scales but eventually slows or declines due to diminishing demand or rising costs.

Marginal revenue curve vs. the demand curve

The marginal revenue curve and the demand curve are linked, but differ in how they represent revenue and consumer behavior. The demand curve shows the maximum price consumers are willing to pay for each unit of a product, while the marginal revenue curve reflects the change in revenue as more units are sold. In markets where businesses can influence price, the marginal revenue curve lies below the demand curve because selling an additional sale often requires lowering prices for all units sold.

For businesses in a perfect competition market, the marginal revenue curve and demand curve align because each additional unit sells at the same price.

Competitive firm vs. monopolies

In a competitive firm, marginal revenue is equal to the market price because firms lack pricing power and must sell at the going rate. This leads to a horizontal marginal revenue curve, indicating that revenue from each additional item remains constant.

On the other hand, a monopoly’s marginal revenue is shaped by its control over pricing. Monopolies face a downward-sloping marginal revenue curve because selling more units requires reducing prices, even for previous sales. This dynamic highlights the monopolist’s ability to set higher prices but also limits the volume of sales due to lower consumer demand. In both cases, businesses use marginal revenue to find the optimal balance between production, pricing, and profitability, whether operating in competitive markets or monopolistic conditions.

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How do businesses use marginal revenue?

Businesses use marginal revenue to inform key decisions about pricing, production, and revenue optimization.

Compare output to revenue

One of the main uses of marginal revenue is comparing the additional revenue from each unit sold to the costs of production.

By evaluating marginal benefit, businesses can determine whether producing and selling more units contributes to overall profitability. For example, if selling an extra unit adds $50 to revenue but production costs increase by $40, the $10 profit margin indicates that increasing output is beneficial. However, if marginal revenue decreases while production costs rise, reducing output might be a better strategy.

Manage production costs

Marginal revenue can also help manage production costs and align them with revenue goals. By comparing marginal revenue to the cost of producing additional units, businesses can avoid overproduction, which can lead to higher expenses and unsold inventory. Companies also monitor demand trends to scale production schedules appropriately in response to market conditions.

Set prices

Businesses rely on marginal revenue to develop effective pricing strategies. By analyzing how revenue changes with each unit sold, companies can identify the optimal price point that balances volume and profit.

For example, for markets with elasticity of demand, setting a lower price can drive higher sales volumes and increase total revenue. For inelastic markets, maintaining higher prices may maximize profitability without significantly affecting demand.

Understanding marginal revenue also helps businesses adjust prices in response to competition, changes in production costs, or shifts in consumer behavior, helping them stay competitive while achieving profit targets.

Frequently asked questions about marginal revenue

Still have questions about the marginal revenue formula? Learn more in the FAQs below.

How is marginal revenue used in cost analysis?

Marginal revenue helps businesses determine whether producing and selling additional units is profitable. By comparing the marginal revenue of each unit sold to the cost of production, businesses can assess whether expanding output will increase overall profitability or lead to diminishing returns.

What is markup pricing?

Markup pricing is a pricing strategy where businesses set the price of a product by adding a predetermined profit margin, or "markup," to its cost of production. This approach ensures that the selling price covers costs and generates a profit. Markup pricing is commonly used in retail and manufacturing industries, where consistent cost structures make it easier to apply a fixed markup percentage.

How are marginal revenue and the demand curve related?

Marginal revenue and the demand curve are closely linked; the shape of the demand curve determines how revenue changes with each additional unit sold. In markets with price elasticity, small price changes can lead to significant shifts in demand, affecting marginal revenue. When demand increases as price decreases, businesses experience positive marginal revenue. However, as prices continue to drop and demand flattens, marginal revenue may decrease or become negative, reflecting diminishing returns.

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