How To Calculate Marginal Revenue (2023)

If your corporation produces 2,000 pairs of jeans every quarter and sells them for $100 each, you may think that selling 20 more pairs will usher in an additional $2,000. Nevertheless it isn’t at all times so straightforward: To sell more, you could need to scale back prices to succeed in more frugal customers. To learn more about how and why this happens, we want to know the right way to calculate marginal revenue and the right way to use the marginal revenue formula to higher gauge profitability.

What’s marginal revenue?

Marginal revenue is the amount of cash generated from selling a further item. The quantity of marginal revenue you gain from producing and selling additional items tends to progressively dwindle, however it is often justifiable so long as it’s profitable—when marginal revenue equals or exceeds the marginal cost of increased production.

Using the marginal revenue formula helps a business determine if it needs to supply roughly to maximise profit. The concept stems from an economic principle often called the law of diminishing returns, which states that in some unspecified time in the future increasing production yields decreasing revenue. The goal of this calculation is to assist a business know when marginal revenue from more production equals the marginal costs. Beyond this breakeven point, additional production is unprofitable because marginal costs exceed marginal revenue—even when the change in total revenue continues to be positive.

Why is marginal revenue essential?

Calculating marginal revenue is very important because it will probably help a business:

• Maximize profit. Marginal revenue minus marginal cost can show you the right way to wring more make the most of additional production.

• Forecast consumer demand. Historical data for marginal revenue allows a business to evaluate the strength of customer demand and the way much they might pay for a business’s products.

• Forecast production. Using demand data, a business can forecast production levels to avoid under or overproducing.

• Set prices. Because marginal revenue reflects the selling price for a further item produced, it will probably be used to find out competitive pricing.

How you can calculate marginal revenue

Marginal revenue is expressed when it comes to either total dollar amounts or individual units. Business managers and analysts typically use the per-unit measure to calculate marginal revenue, comparing changes in per-unit revenue from increased production. The marginal revenue formula is as follows:

Marginal revenue = Change in total revenue / Change in quantity

For instance, the jeans company mentioned above has quarterly revenue of $200,000, selling 2,000 jeans at $100 each. Imagine that it decides to supply five more pairs of jeans and sells them for a complete of $450. Divide this total increase in revenue by the five additional pairs of jeans to find out marginal revenue, which on this case is $90 a pair.

Marginal revenue = $450 / 5 = $90

This marginal revenue figure is lower than the $100 per pair from current production.

Now, imagine the corporate decides to make 10 additional pairs, and total revenue increases by $800. The marginal revenue formula for this variation in quantity then is:

Change in total revenue / Change in quantity = $800 / 10 = $80

In other words, marginal revenue from this batch of 10 additional pairs of jeans is $80 each.

Over again, let’s say the corporate boosts output by 15 pairs of jeans, leading to a $1,050 revenue increase. Per-pair marginal revenue from this variation in quantity is:

$1,050 / 15 = $70

These examples using the marginal revenue formula illustrate the law of diminishing returns based on a rising change in quantity. Because the jeans manufacturer steps up production, the marginal revenue per additional unit diminishes although the change in total revenue continues rising.

In one other scenario, perhaps more realistic, let’s say the jeans maker considers increasing production by increments of 100 pairs. Assume the production cost is $75 per pair. Here’s what a hypothetical schedule of marginal revenue calculations using the marginal revenue formula might seem like:

So the jeans maker could produce as many 2,400 pairs of jeans, or 400 greater than current production, to generate marginal revenue as much as the purpose where it equals the associated fee of production, or $75 per pair.

How you can calculate marginal cost

The above example assumes that the production cost of a pair of jeans stays at $75. In the actual world, marginal costs of additional production eventually rise. These are frequently resulting from variable costs, similar to labor and raw materials. For example, if the jeans maker has to pay additional time to employees or pay more for denim fabric, its marginal costs rise.

Calculating marginal cost uses a formula much like the marginal revenue formula:

Marginal cost = Change in total cost / Change in quantity

A schedule of the jeans company’s marginal revenue together with marginal cost based on change in quantity of output might seem like this:

From this schedule, the jeans company can see that producing one other 200 pairs continues to be profitable because marginal revenue of $85 a pair exceeds the extra cost of $80. But somewhere between making 200 and 300 additional pairs, increased production isn’t any longer profitable: Marginal revenue of $80 a pair matches the marginal costs.

What’s a marginal revenue curve?

The marginal revenue curve is a graphical representation of how marginal revenue changes as production increases. It also shows the purpose where marginal cost intersects with marginal revenue—where further production becomes unprofitable unless a business can cut manufacturing costs.

Within the graph below, the downward-sloping straight lines represent marginal revenue and demand, while the upward-sloping curved line is for marginal cost. The marginal cost curve gets its shape from the undeniable fact that production costs are inclined to fall at first as output ramps up and the business enjoys economies of scale. After that, nonetheless, costs then start rising rapidly as the corporate strains to extend production.

The graph has the vertical Y-axis showing price (in addition to marginal revenue and marginal cost), and the horizontal X-axis showing the amount of production. The demand line can also be called the common revenue line. The downward slope of the lines from left to right reflects an inverse relationship between a product’s price and its demand—as a product’s price declines, demand for it increases, and vice versa. The economic principle behind this inverse relationship is often called price elasticity of demand, meaning the extent to which demand changes when a product’s price rises or falls.

The marginal revenue line is often below the demand line because marginal revenue is lower than average revenue for a given level of production, because the graph above shows.

Demand is elastic (meaning it’s sensitive to cost changes) when marginal revenue is positive, meaning anywhere on the Y-axis above zero. Also, competitive businesses will keep producing until marginal revenue and marginal cost turn out to be equal.