Understanding how a business generates revenue requires analyzing how each additional unit of output impacts the bottom line. Marginal Revenue (MR) is the specific metric used to gain this insight, serving as an indicator of financial performance. By tracking this figure, managers and owners can accurately gauge the profitability of scaling operations. Analyzing marginal revenue provides the necessary data to determine the most beneficial level of production that maximizes financial returns.
Defining Marginal Revenue
Marginal Revenue represents the change in a company’s total revenue that results from selling one additional unit of a product or service. This concept is foundational in microeconomics, providing a lens through which firms can evaluate the financial implications of incremental changes in output. It is the revenue earned from the last unit sold, separate from the revenue generated by all preceding units.
Businesses track marginal revenue to understand the immediate financial consequence of expanding their scale of production. If the revenue gained from the next unit is positive, it signals that increasing output is adding value to the company’s income stream. This metric allows a firm to make informed decisions about whether to increase, decrease, or maintain its current output levels based on the sales performance of the last item. Unlike profit, marginal revenue is solely focused on the income generated and does not yet account for the costs associated with producing the unit.
Calculating Marginal Revenue Step-by-Step
Calculating marginal revenue involves a straightforward comparison between the total revenue at two different output levels. The formal calculation is expressed as the change in total revenue divided by the change in the quantity of units sold. This relationship, $\text{MR} = \frac{\text{Change in Total Revenue}}{\text{Change in Quantity}}$, provides the precise revenue contribution of the extra units.
For instance, a company sells 10 units for a total revenue of \$100. If the company decides to increase production and sells 11 units, and the new total revenue is \$105, the marginal revenue is \$5. This is derived by taking the \$5 increase in total revenue (\$105 – \$100) and dividing it by the single-unit increase in quantity (11 – 10). The resulting figure of \$5 represents the specific revenue generated by that eleventh unit.
The Relationship Between Marginal Revenue and Price
For most businesses, marginal revenue is typically less than the price of the product itself. This distinction arises because these firms face a downward-sloping demand curve, meaning they must lower the selling price to attract buyers for additional units. To sell one more unit, the company must often drop the price not only for that unit but also for all previous units sold at the higher price point.
The marginal revenue calculation captures the net effect of this transaction: the revenue gained from the new unit minus the revenue lost on existing units due to the price reduction. Because of this trade-off, the marginal gain from selling an extra unit declines faster than the product’s price as output increases. This is why the marginal revenue curve for most firms lies below the demand curve, which represents the price.
Marginal Revenue vs. Total and Average Revenue
Marginal Revenue (MR) is distinct from both Total Revenue (TR) and Average Revenue (AR), though all three metrics are interconnected indicators of a firm’s sales performance. Total revenue represents the entire amount of income generated from the sale of all goods and services over a specified period. It is calculated by multiplying the price per unit by the total quantity of units sold.
Average revenue (AR), on the other hand, measures the revenue generated per unit sold and is calculated by dividing total revenue by the quantity sold. Average revenue is always equal to the price of the product, as it reflects the average amount received for each item. Marginal revenue acts as the instantaneous rate of change of total revenue, meaning it represents the slope of the total revenue curve at any given output level. When marginal revenue is positive, total revenue is increasing; when marginal revenue is zero, total revenue has reached its maximum point.
Using Marginal Revenue for Profit Maximization
The primary application of marginal revenue is its use in the profit maximization rule, which determines the optimal output level for any firm. This rule states that a business should continue to increase production up to the point where marginal revenue equals marginal cost ($\text{MR} = \text{MC}$). Marginal cost is the additional expense incurred to produce that final unit of output.
The rationale behind this rule is straightforward: as long as the revenue gained from selling one more unit (MR) is greater than the cost of producing it ($\text{MR} > \text{MC}$), the company adds to its total profit. If a firm finds itself in this situation, it should increase production to capture those remaining profitable opportunities. Conversely, if the cost of producing the last unit exceeds the revenue it brings in ($\text{MR} < \text{MC}$), the company is losing money on that unit and should reduce output. The point where the additional revenue exactly covers the additional cost is where total profit is maximized, and any deviation in output would result in a lower overall profit.
Special Cases: Perfect Competition vs. Monopoly
The relationship between marginal revenue and price is significantly altered by the specific market structure in which a firm operates. In a perfectly competitive market, individual firms are considered “price takers” because they are too small to influence the market price. Since a competitive firm can sell any quantity at the prevailing market price, the revenue gained from each additional unit is constant, meaning marginal revenue is always equal to the price ($\text{MR} = \text{P}$).
A monopoly, or a firm with significant market power, operates as a “price setter” and faces the entire market’s downward-sloping demand curve. Because the monopolist must lower the price across all units to sell an additional one, its marginal revenue is always less than the price ($\text{MR} < \text{P}$). This difference means the monopolist's marginal revenue curve lies below its demand curve, fundamentally changing how it approaches the profit maximization rule compared to a competitive firm.