What Is Marginal Revenue (MR)?
Marginal revenue is the increase in revenue that results from the sale of one additional unit of output. While marginal revenue can remain constant over a certain level of output, it follows the law of diminishing returns and will eventually slow down as the output level increases. Perfectly competitive firms continue producing output until marginal revenue equals marginal cost.
- Marginal revenue helps a company identify the revenue generated from one additional unit of production.
- A company that is looking to maximize its profits will produce up to the point where marginal cost equals marginal revenue.
- When marginal revenue falls below marginal cost, firms typically do a cost-benefit analysis and halt production
How Marginal Revenue Works
A company calculates marginal revenue by dividing the change in total revenue by the change in total output quantity. Therefore, the sale price of a single additional item sold equals marginal revenue. For example, a company sells its first 100 items for a total of $1,000. If it sells the next item for $8, the marginal revenue of the 101st item is $8. Marginal revenue disregards the previous average price of $10, as it only analyzes the incremental change.
Any benefits gained from adding the additional unit of activity are marginal benefits. One such benefit occurs when marginal revenue exceeds marginal cost, resulting in a profit from new items sold. A company experiences best results when production and sales continue until marginal revenue equals marginal cost. Beyond that point, the cost of producing an additional unit will exceed the revenue generated. When marginal revenue falls below marginal cost, firms typically adopt the cost-benefit principle and halt production, as no further benefits are gathered from additional production.
Example of Marginal Revenue
To assist with the calculation of marginal revenue, a revenue schedule outlines the total revenue earned as well as the incremental revenue for each unit. The first column of a revenue schedule lists the projected quantities demanded in increasing order, and the second column lists the corresponding market price. The product of these two columns results in projected total revenues, in column three.
The difference between the total projected revenue of one quantity demanded and the total projected revenue from the line below it is the marginal revenue of producing at the quantity demanded on the second line. For example, 10 units sell at $9 each, resulting in total revenues of $90; 11 units sell at $8.50, resulting in total revenues of $93.50. This indicates the marginal revenue of the 11th unit is $3.50 ($93.50 - $90).
Competitive Firms vs. Monopolies
Marginal revenue for competitive firms is typically constant. This is because the market dictates the optimal price level and companies do not have much – if any – discretion over the price. As a result, perfectly competitive firms maximize profits when marginal costs equal market price, and marginal revenue. Marginal revenue works differently for monopolies. For a monopolist, the marginal benefit of selling an additional unit is less than the market price.
A perfectly competitive firm can sell as many units as it wants at the market price, whereas the monopolist can do so only if it cuts prices for its current and subsequent units.
A firm's average revenue is its total revenue earned divided by the total units. A competitive firm’s marginal revenue always equals its average revenue and price. This is because the price remains constant over varying levels of output. In a monopoly, because the price changes as the quantity sold changes, marginal revenue diminishes with each additional unit and will always be equal to or less than average revenue.