Marginal Revenue Formula

What Is Marginal Revenue?

The additional revenue generated by the deal of each additional unit is called marginal revenue (MR).

This revenue can remain stable for a company over some time. Still, after a certain point, it starts reducing due to the law of diminishing returns because of the increased output levels. 

However, in economics, it is believed that firms operating in a perfectly competitive industry should continue their operations until MR equals marginal cost.

This revenue can be generated by dividing the change in total revenue by the change in total units sold. Thus, the increase in revenue due to additional units equals marginal revenue. Therefore, it focuses only on the incremental change in income. 

The formula to calculate is:

MR = Change in Revenue/ Change in Quantity

Or

△TR/△Q

For example, a company used to sell 700 units of product for $14,000. However, it realizes that to increase the sales, it needs to decrease the price to $18, thus increasing the company's sales to 1000 units. For each extra unit sold, MR is equal to:

(Revenue by selling 1000 units - revenue by selling 700 units)/300

$18,000 - $14,000/300

= $4000/300 = $13.33 per unit

Benefits from the sale of additional units are called marginal benefits; therefore, as the revenue surpasses the marginal cost, the extra profit generated from selling that another unit is an example of marginal benefits.

A company can maximize its profits where MR equals the marginal cost; after that stage, there is no benefit of selling additional units as the marginal cost is more than the revenue generated by selling that unit.

When such a situation arises, the company should stop production or cut costs to reduce the marginal cost below the marginal revenue. Otherwise, the firm would be unable to survive in the market and risk going bankrupt.

Importance Of Marginal Revenue

It has many financial, accounting, and economic applications. But first, it helps the management dive deeper into the following points:

• They analyze the market size for a particular product. Estimates that vary too much from the actual market size would lead to either shortage of inventory or excess production, leading to very high costs for the company.
• Price setting can also affect production schedules. If the price is high, the company will profit more from each unit, but the number of units sold decreases, ultimately reducing the revenue.
• Planning of production schedules based on demand for a product.

It can affect a product's price and production levels in an industry. However, in reality, the marginal revenue is equal to the market price in a perfectly competitive industry.

Since substitutes are available, a price increase by a manufacturer would result in a loss of sales. However, in industries where reserves are not available, along with a low supply of products, production can affect the market price for the product.

Thus, a lack of supply will result in increased demand, and the customers will have to pay a higher price. Therefore, the company can MR within the price elasticity curve, which can be adjusted to maximize profitability.

Example Of Marginal Revenue Formula

A revenue schedule helps to understand the total and additional revenue generated by selling a different unit.

The first column of the revenue schedule consists of the quantities demanded in increasing order. In contrast, the second column includes the market prices corresponding to a particular level of demand. Finally, by multiplying these numbers, we get the total revenues generated.

For example, XYZ Ltd. sells shoes to a wholesaler at $20 per pair and 1000 units, currently generating $20,000. However, if they sell 1100 pairs, they would have to deal with them at $19.5, resulting in a total revenue of $21,450.

Now,

MR for each unit = (21450 - 20000) / 100

= $14.5

Marginal Revenue Curve

MR is generally stable and constant because the business sells the product at the same price to every customer, thus making the marginal revenue for each unit equal. 

However, MC can be different for different production levels because as a company grows, it benefits from the economies of scale.

Moreover, inefficiency starts to creep into the organization after a certain production level. This phase in which inefficiencies arise is called diseconomies of scale, thus increasing the marginal cost. 

The firm can maximize its profits when MC is equal to MR. Therefore, at this point, the firm should stop increasing its production levels.

Exploring MR for Competitive Firms and Monopolies

Firms operating in competitive industries generally have a constant marginal revenue because they are not the price makers. Instead, the market decides the price at which the goods will be sold. Thus companies do not have much power to influence prices.

For a company operating in a perfectly competitive market like FMCG, maximum profit is earned when marginal revenue equals marginal cost and even the market price. 

However, marginal revenue is different for a monopoly firm that benefits less than the market price of a product by selling an additional unit.

A perfectly competitive industry’s firms can increase their revenue and, in turn, their profits by selling more units at market prices. However, a monopolist firm can increase its sales only when it cuts product prices.

The average revenue is obtained by dividing total revenue by the total number of units sold during a particular time period. Since the prices of a competitive firm’s products remain the same, the average revenue is always equal to its marginal revenue and market price.

However, when looking at a monopoly, since the price has to be increased to increase the number of goods sold, the revenue reduces with each additional unit sold and is less than average.

Researched and authored by Kunal Goel | LinkedIn

Free Resources 

To continue learning and advancing your career, check out these additional helpful WSO resources:

 

• Fixed and Variable Costs
• Marginal Cost Formula
• Marginal Cost of Production
• Marginal Revenue Formula
• Step Costs​