It’s essential to understand the numbers behind your business, especially when it comes to revenue. But what about marginal revenue? Find out everything you need to know, starting with our marginal revenue definition.
Marginal revenue definition
Marginal revenue refers to the change in total revenue as a result of selling an additional unit.
The purpose of marginal revenue is to improve the accuracy of your calculations in a world where the law of diminishing returns suggests that your earnings will lessen over time. This law takes into account the elements of the market that can impact your sales figures, like supply and demand. Furthermore, it is useful for understanding how making changes, like increasing production (which increases marginal cost), won’t improve sales if pricing remains the same.
Essentially, marginal revenue shows how your changes have impacted overall revenue. A company that wants to maximise profits will aim for a marginal cost equal to marginal revenue. If the reverse becomes true, it’s common for companies to stop production until the situation can be remedied.
How to calculate marginal revenue
You can calculate marginal revenue by taking the total revenue change and the change in total output and dividing them. The marginal revenue formula is as follows:
Marginal Revenue = Change in Revenue / Change in Quantity
For example, if a company sells 100 units of an item for $1,000 and then sells an additional five units for $500, the marginal revenue of each additional unit is $100 ($500/5).
What is the marginal revenue curve?
The marginal revenue curve is a visual illustration of marginal cost. Viewed on a chart, the marginal cost curve has a U-shape, as the more units you make, the more you pay in production costs. The marginal revenue curve is more of a downward slope. As the number of units increases, the sale price will need to decrease to meet the needs of supply and demand.
Competitive companies vs. monopolies
Marginal revenue should stay relatively stable for competitive firms – on the chart mentioned above, demand and marginal revenue should always be more or less parallel to answer the needs of the market. A competitive firm can virtually sell as many units as it desires and still have marginal cost and revenue remain equal, but a firm that holds a monopoly on the market must strategize differently.
What is a monopoly?
A monopoly seller is a single seller of a good or service in a market. On the one hand, this is extremely fortunate as the brand has a captured market. However, these types of businesses must consider their marginal revenue much more closely. Generally speaking, a monopolist will not be able to shift as many units as a competitive seller, simply because it is a single supplier, rather than one seller among thousands.
Imagine that Company A, a producer of makeup sponges, charges $20 per unit. If it were selling just 1,000 units, small supply vs. large demand would make $20 a fair sales price. However, they decide to expand and increase the cost to $30, and their customers refuse to pay the new price. This is because customers that consider the price too high will seek out alternatives. Supply now equals demand, and the price must reflect this. Hence, Company A may decide to reduce prices. This impacts the marginal revenue, which will also decrease.
If you were to graph the marginal revenue and demand of a monopoly, they would both be downward slopes that slowly grow further apart.
Why is marginal revenue significant?
Marginal revenue is the money made when production and other costs have been considered. It’s an important number to focus on if you want to maximise profit. Unlike standard revenue, marginal revenue gives you a better insight into the effectiveness of your current business operations.
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