What Is Marginal Revenue?
Marginal revenue is the additional income generated from selling one more unit of a good or service. It is a fundamental concept in microeconomics that businesses use to determine the optimal level of production to achieve profit maximization. When a company considers increasing its output, understanding marginal revenue helps in evaluating whether the additional sales will lead to a net gain in overall revenue. This metric is crucial for a firm's pricing strategy and helps in making incremental decisions about production adjustments.
History and Origin
The concept of marginal revenue, as part of broader marginal analysis, emerged during the "Marginal Revolution" in economics during the 1870s. This intellectual shift marked a departure from the classical economists' cost-of-production theory of value, instead emphasizing the subjective utility or satisfaction derived from consuming an additional unit of a good. Key figures independently developing these ideas included William Stanley Jevons in England, Carl Menger in Austria, and Léon Walras in Switzerland, who are considered the founders of marginalism. 9Their work established that the economic value of a good is determined by the benefit an individual consumer attributes to the last, or "marginal," unit consumed, which subsequently influenced how firms viewed the additional revenue from selling one more unit. 8Alfred Marshall, a prominent British economist, later synthesized these marginalist ideas with classical concepts of supply and demand, popularizing the modern neoclassical approach that underpins much of today's microeconomics.
Key Takeaways
- Marginal revenue is the additional income a company earns by selling one more unit of a product or service.
- Businesses typically increase production as long as marginal revenue exceeds marginal cost.
- To maximize profits, a firm will ideally produce at the point where marginal revenue equals marginal cost.
- In a perfect competition market, marginal revenue typically equals the market price.
- In imperfectly competitive markets (such as a monopoly), marginal revenue often declines as more units are sold because prices must be lowered to sell additional quantities.
Formula and Calculation
The formula for marginal revenue (MR) calculates the change in total revenue divided by the change in the quantity of output sold.
Where:
- (MR) = Marginal Revenue
- (\Delta TR) = Change in Total Revenue
- (\Delta Q) = Change in Quantity Sold
For example, if a company's total revenue increases from $1,000 to $1,050 when production increases from 100 units to 101 units, the marginal revenue for that 101st unit is $50.
Interpreting the Marginal Revenue
Interpreting marginal revenue is central to a firm's decision-making regarding production levels. A positive marginal revenue indicates that selling an additional unit increases the company's total income. As long as marginal revenue is greater than marginal cost, a firm can increase its profits by producing more. Conversely, if marginal revenue is less than marginal cost, producing that additional unit would decrease overall profit, as the cost of production outweighs the revenue generated. The goal for any profit-maximizing firm is to produce up to the point where marginal revenue precisely equals marginal cost. This point represents the economic equilibrium for the firm's output.
In markets with perfect competition, firms are price takers, meaning they cannot influence the market price. In such a scenario, the marginal revenue for each additional unit sold is equal to the market price. However, in markets with imperfect competition, such as monopolies or oligopolies, firms often face a downward-sloping demand curve. This means that to sell more units, they typically must lower the price not just for the additional units, but for all units sold. As a result, marginal revenue will usually be less than the average revenue and will decline as more units are sold.
Hypothetical Example
Consider "Sweet Treats Bakery," which specializes in custom cakes.
- When Sweet Treats sells 5 cakes, their total revenue is $500.
- They consider baking a 6th cake. The ingredients and labor for this additional cake cost them $60.
- They manage to sell the 6th cake for $90, bringing their new total revenue to $590.
To calculate the marginal revenue for the 6th cake:
(\Delta TR = \text{New Total Revenue} - \text{Old Total Revenue} = $590 - $500 = $90)
(\Delta Q = \text{New Quantity} - \text{Old Quantity} = 6 - 5 = 1 \text{ cake})
(MR = \frac{$90}{1} = $90)
In this scenario, the marginal revenue for the 6th cake is $90. Since their marginal cost for that cake was $60, and the marginal revenue ($90) exceeds the marginal cost, producing and selling the 6th cake was a profitable decision, increasing the bakery's overall profit by $30.
Practical Applications
Marginal revenue is a cornerstone of economic decision-making for businesses across various industries. Companies use it extensively in determining optimal production levels and pricing strategy. For instance, manufacturers apply marginal analysis to decide how many units to produce: if the marginal cost of producing an additional unit is lower than the marginal revenue it generates, increasing production makes economic sense. 7Conversely, if the marginal cost exceeds marginal revenue, further production becomes unprofitable.
6
Beyond production, marginal revenue analysis extends to hiring decisions, marketing campaigns, and investment appraisals. A firm might use it to assess whether adding another employee will generate enough additional revenue to cover their wages and benefits. In the realm of regulation, concepts related to marginal revenue, particularly in the context of market power and pricing, are central to antitrust laws enforced by entities like the U.S. Department of Justice. 5These laws aim to prevent anti-competitive practices, such as certain forms of monopoly behavior, that could lead to consumer harm through inflated prices or reduced choices.
Limitations and Criticisms
While marginal revenue is a powerful tool in microeconomics and business decision-making, its practical application has certain limitations. Economic models, including those that rely on marginal revenue, often operate under simplifying assumptions, such as perfect information and rational behavior, which may not always hold true in real-world scenarios. 4Factors like emotional influences, social norms, and cognitive biases can impact actual decision-making, deviating from purely rational economic predictions.
2, 3
Furthermore, accurately calculating marginal revenue can be challenging in dynamic markets. It requires precise data on how changes in output affect total revenue, which can be difficult to isolate, especially when multiple variables are changing simultaneously. For instance, a change in price might not solely affect the quantity demanded due to other market factors, making the true marginal revenue difficult to ascertain. Models that omit important issues like externalities or fail to account for unforeseen events can lead to inaccurate predictions. 1Moreover, the "law of diminishing marginal returns," which suggests that marginal revenue will eventually decrease as production increases, assumes that all other factors of production remain constant—a condition rarely met in complex business environments.
Marginal Revenue vs. Average Revenue
Marginal revenue and average revenue are distinct but related concepts vital for understanding a firm's sales performance. Marginal revenue, as discussed, is the additional revenue generated by selling one more unit. It focuses on the incremental change in total revenue.
Average revenue, on the other hand, is the total revenue divided by the total quantity of units sold. It represents the revenue per unit on average. In a market characterized by perfect competition, where firms are price takers, marginal revenue equals average revenue (and the market price) because each additional unit is sold at the same constant price. However, in imperfectly competitive markets (e.g., monopoly), a firm typically must lower its price to sell additional units, which means the marginal revenue for an extra unit will be less than the average revenue for all units sold. This relationship is crucial for firms with market power, as their marginal revenue demand curve lies below their average revenue (or price) curve.
FAQs
Why is marginal revenue important for businesses?
Marginal revenue is crucial for businesses because it helps them make informed decisions about how much to produce to maximize their profits. By comparing the additional revenue from selling one more unit with the marginal cost of producing it, companies can determine the optimal output level where profits are highest.
How does market structure affect marginal revenue?
Market structure significantly affects marginal revenue. In perfect competition, firms are price takers, so marginal revenue equals the market price. In imperfect competition (like monopoly), firms face a downward-sloping demand curve, meaning they must lower prices to sell more units. Consequently, marginal revenue will be less than the price and will decline as more units are sold.
Can marginal revenue be negative?
Yes, marginal revenue can be negative. This occurs when selling an additional unit requires a significant price reduction across all units sold, leading to a decrease in overall total revenue. If a firm continues to increase production beyond the point where marginal revenue equals zero, it means each additional unit sold actually reduces the company's total income.
What is the relationship between marginal revenue and price elasticity of demand?
Marginal revenue is closely related to price elasticity of demand. When demand is elastic (meaning a small price change leads to a large change in quantity demanded), marginal revenue is positive. When demand is unit elastic, marginal revenue is zero. When demand is inelastic (meaning a large price change leads to a small change in quantity demanded), marginal revenue is negative, indicating that further price reductions to sell more units will decrease total revenue.