What are Marginal Revenues?
Marginal revenues are the amount of money generated from the sale of an additional unit. The amount of marginal revenue obtained from producing and selling additional items tends to decrease gradually, but it is usually justified as long as it is profitable – when marginal revenue equals or exceeds the marginal cost of increasing production.
Why are Marginal Revenues Important?
Calculating marginal revenues is important because it can help the company to:
- Maximize profit. Marginal revenue minus marginal cost can show you how to achieve more profit from additional production.
- Forecast customer demand. Historical data on marginal revenue allows you to assess the strength of customer demand and how much they may pay for the company’s products.
- Anticipate production. By using demand data, the company can forecast production levels to avoid underproduction or overproduction.
- Set prices. Since marginal revenue reflects the selling price of an additional unit produced, it can be used to determine competitive pricing.
How to Calculate Marginal Revenues
Marginal revenues are expressed in total monetary amounts or individual units. Business managers and analysts typically use the unit-related ratio to calculate marginal revenues, by comparing changes in revenue to each additional unit of production. The formula for marginal revenue is as follows:
Marginal Revenue = Change in Total Revenue / Change in Quantity
For example, a jeans company has quarterly revenues of $200,000, selling 2,000 jeans at $100 each. Suppose it decides to produce five additional pairs of jeans and sells them for a total of $450. Divide this total increase in revenue by the five additional pairs to determine the marginal revenue, which in this case is $90 per pair.
Marginal Revenue = $450 / 5 = $90
This amount of marginal revenue is less than $100 for each pair of current production.
Now, suppose the company decides to produce 10 additional pairs, increasing total revenue by $800. The formula for marginal revenue for this change in quantity is as follows:
Change in Total Revenue / Change in Quantity = $800 / 10 = $80
In other words, the marginal revenue from this batch of 10 additional pairs of jeans is $80 per pair.
Again, let’s assume the company increases production by 15 pairs of jeans, resulting in an increase in revenue of $1,050. The marginal revenue for each pair from this change in quantity is:
$1,050 / 15 = $70
These examples illustrate using the marginal revenue formula and demonstrate the principle of diminishing returns based on an increase in the change in quantity. As the jeans company increases production, the marginal revenue for each additional unit decreases even though total revenue continues to rise.
In another scenario, perhaps more realistic, let’s assume the jeans maker considers increasing production in increments of 100 pairs. Suppose the cost of production is $75 per pair. Here’s what a potential table for marginal revenue calculations could look like using the marginal revenue formula:
Additional Production / Total Revenue – Original Revenue = Change in Revenue / Change in Production = Marginal Revenue per Pair of Jeans
100 / 209,000 – 200,000 = 9,000 / 100 = $90
200 / 217,000 – 200,000 = 17,000 / 200 = $85
300 / 224,000 – 200,000 = 24,000 / 300 = $80
400 / 230,000 – 200,000 = 30,000 / 400 = $75
Thus, the jeans maker can produce up to 2,400 pairs of jeans, or 400 additional pairs beyond the current production, to generate marginal revenues that reach the point where they equal the cost of production, which is $75 per pair.
How to
Calculating Marginal Cost
The example above assumes that the cost of producing a pair of jeans remains at $75. In the real world, marginal production costs eventually rise. This is usually due to variable costs, such as labor and raw material costs. For example, if a jean maker has to pay extra wages for workers or pay more for denim fabric, their 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 marginal revenue for a jean company with marginal cost based on the change in production quantity might look as follows:
100 / 9,000 / 100 = $80
200 / 17,000 / 200 = $80
300 / 24,000 / 300 = $80
From this table, the jean 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. However, at some point between producing 200 and 300 additional pairs, further production is no longer profitable: the marginal revenue of $80 per pair matches the marginal costs.
What is the 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 additional production becomes unprofitable unless the company can reduce manufacturing costs.
In the graph below, the downward-sloping straight lines represent marginal revenue and demand, while the upward-sloping curved line represents the marginal cost curve. The shape of the marginal cost curve comes from the fact that production costs decrease initially as production increases, allowing the company to enjoy economies of scale. After that, costs start to rise rapidly as the company seeks to increase production.
The graph shows the vertical Y-axis as price (as well as marginal revenue and marginal cost), and the horizontal X-axis as the quantity produced. The demand line is also called the average revenue line. The downward slope of the lines from left to right reflects the inverse relationship between the price of the product and its demand—as the price of the product decreases, demand for it increases, and vice versa. The economic principle behind this inverse relationship is known as the price elasticity of demand, which refers to how much demand changes when the price of a product rises or falls.
Typically, the marginal revenue line lies below the demand line because marginal revenue is less than average revenue at a given level of production, as shown in the graph above.
Demand is elastic (meaning it is sensitive to price changes) when marginal revenue is positive, that is, anywhere on the vertical axis above zero. Additionally, competitive firms will continue to produce until marginal revenue equals marginal cost.
Queries About Marginal Revenue Calculation
What is marginal revenue used for?
It is important for companies to know how to calculate marginal revenue, as it can help to maximize profits. It also assists in forecasting customer demand and production, as well as setting prices.
Is marginal revenue the same as profit?
No, marginal revenue is different because it does not take costs into account. Profit is the marginal revenue, derived from the specific 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 from producing and selling an 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?
The cost-benefit analysis helps the company determine the point at which marginal production costs equal marginal revenue. This is the company’s maximum profit point. Beyond that point, the marginal cost exceeds the marginal revenue, and the company is producing at a loss. The company must decide either to reduce the number of units produced or to decrease production costs to return to profitability.
Source: https://www.shopify.com/blog/how-to-calculate-marginal-revenue
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