If your company produces 2,000 pairs of jeans each quarter and sells them for $100 each, you might think that selling 20 more pairs will bring in $2,000 more. But it’s not always that simple: to sell more, you may have to reduce prices to reach more thrifty customers. To learn more about how and why this happens, we need to understand how to calculate marginal revenue and how to use the marginal revenue formula to better assess profitability.
What is marginal revenue?
Marginal revenue is the amount of money generated from the sale of an additional item. The amount of marginal revenue you earn from producing and selling additional items tends to gradually decrease, but it is generally justifiable as long as it is profitable, when the marginal revenue is equal to or greater than the marginal cost of increasing the production.
Using the marginal revenue formula helps a company determine whether it should produce more or less to maximize profits. The concept stems from an economic principle known as the law of diminishing returns, which states that, at some point, an increase in production leads to a decrease in income. The purpose of this calculation is to help a business know when marginal revenue from increased production equals marginal costs. Beyond this break-even point, additional production is not profitable because marginal costs exceed marginal revenues, even if the change in total revenues remains positive.
Why is marginal revenue important?
Calculating marginal revenue is important because it can help a business:
- Maximize profits. Marginal revenue minus marginal cost can show you how to get more profit from additional production.
- Forecast consumer demand. Historical marginal revenue data allows a company to gauge the strength of customer demand and how much they would pay for a company’s products.
- Forecast production. Using demand data, a company can forecast production levels to avoid underproduction or overproduction.
- Set prices. Since marginal revenue reflects the selling price of an additional item produced, it can be used to determine competitive prices.
How to Calculate Marginal Revenue
Marginal revenues are expressed either in total dollar amounts or in individual units. Business managers and analysts typically use the per-unit measure to calculate marginal revenue, comparing changes in revenue per unit resulting from increased production. The formula for marginal revenue is:
Marginal revenue = Change in total revenue / Change in quantity
For example, the jeans company mentioned above has quarterly sales of $200,000 and sells 2,000 pairs of jeans at $100 each. Imagine she decides to produce five more pairs of jeans and sell them for a total of $450. Divide this total increase in revenue by the five additional pairs of jeans to determine the marginal revenue, which in this case is $90 per pair.
Marginal income = $450 / 5 = $90
This marginal revenue figure is less than the $100 per pair of current production.
Now imagine that the company decides to make 10 more pairs and total revenue increases by $800. The marginal revenue formula for this change in quantity is then:
Change in total revenue / Change in quantity = $800 / 10 = $80
In other words, the marginal revenue from this set of 10 extra pairs of jeans is $80 each.
Again, let’s say the company increases its production by 15 pairs of jeans, resulting in an increase in revenue of $1,050. The marginal revenue per pair resulting from this change in quantity is:
$1,050 / 15 = $70
These examples using the marginal revenue formula illustrate the law of diminishing returns based on increasing change in quantity. As the jeans manufacturer increases production, the marginal revenue per additional unit decreases even though the change in total revenue continues to increase.
In another, perhaps more realistic, scenario, let’s say the jeans manufacturer plans to increase production in increments of 100 pairs. Assume the production cost is $75 per pair. Here’s what a hypothetical schedule of marginal revenue calculations using the marginal revenue formula might look like:
100 | $209,000 – 200,000 = $9,000 | $9,000 | $9,000 / 100 | $90 |
200 | $217,000 – 200,000 = $17,000 | $17,000 | $17,000 / 200 | $85 |
300 | $224,000 – 200,000 = $24,000 | $24,000 | $24,000 / 300 | $80 |
400 | $230,000 – 200,000 = $30,000 | $30,000 | $30,000 / 400 | $75 |
So the jeans manufacturer could produce up to 2,400 pairs of jeans, or 400 more than current production, to generate marginal revenue up to the point where it would equal the cost of production, or $75 per pair.
How to Calculate Marginal Cost
The example above assumes that the cost of producing a pair of jeans remains at $75. In the real world, the marginal costs of additional production eventually increase. These are usually due to variable costs, such as labor and raw materials. For example, if the jeans manufacturer has to pay its workers overtime or pay more for denim fabric, its marginal costs increase.
Calculating marginal cost uses a formula similar to the marginal revenue formula:
Marginal cost = Change in total cost / Change in quantity
A table of the jeans company’s marginal revenue and marginal cost based on changes in production quantity might look like this:
100 | $9,000 | $90 | $8,000 | $8,000/100 | $80 |
200 | $17,000 | $85 | $16,000 | $16,000/200 | $80 |
300 | $24,000 | $80 | $24,000 | $24,000/300 | $80 |
From this schedule, the jeans company can see that producing an additional 200 pairs is still profitable because the marginal revenue of $85 per pair exceeds the additional cost of $80. But between 200 and 300 additional pairs, the increase in production is no longer profitable: the marginal revenue of $80 per pair corresponds to the marginal costs.
What is a marginal revenue curve?
The marginal revenue curve is a graphical representation of how marginal revenue changes as production increases. It also shows the point where marginal cost intersects with marginal revenue, where continued production becomes unprofitable unless a company can reduce its manufacturing costs.
In the chart below, the straight downward lines represent marginal revenue and demand, while the curved upward line represents marginal cost. The marginal cost curve gets its shape because production costs tend to fall initially as production increases and the firm benefits from economies of scale. After that, however, costs begin to rise rapidly as the company strives to increase production.
The chart has a vertical Y axis showing price (as well as marginal revenue and marginal cost) and a horizontal X axis showing quantity of production. The demand line is also called the average income line. The downward slope of the lines from left to right reflects an inverse relationship between the price of a product and its demand: as the price of a product decreases, demand increases, and vice versa. The economic principle behind this inverse relationship is known as price elasticity of demand, which is the extent to which demand changes when the price of a product increases or decreases.
The marginal revenue line is generally lower than the demand line because marginal revenue is lower than the average revenue for a given level of production, as shown in the graph above.
Demand is elastic (i.e., sensitive to price changes) when marginal revenue is positive, i.e., anywhere on the Y axis above zero . Furthermore, competitive firms will continue to produce until marginal revenues and marginal costs become equal.
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How to Calculate Marginal Revenue FAQ
What is marginal revenue used for?
It’s important for businesses to know how to calculate marginal revenue, and comparing the results to increased costs can help a business maximize profits. Using the marginal revenue formula also helps in forecasting customer demand and production, as well as setting sales prices.
Is marginal revenue the same as profit?
No. Marginal revenue is different because it does not take into account costs. Profit is marginal revenue, derived from the marginal revenue formula, minus the cost of producing each additional unit.
What is the difference between marginal revenue and marginal cost?
Marginal revenue is the change in revenue received for producing and selling one additional unit of a product or service. Marginal cost is the money spent to increase the number of units sold.
How is marginal revenue used in cost-benefit analysis?
Cost-benefit analysis helps a company determine the point where marginal costs of production equal marginal revenue. This is the goal of maximum profit for a business. Beyond this point, marginal cost exceeds marginal revenue and the firm produces at a loss. It must decide either to reduce the number of units produced or to reduce production costs to return to profitability.