Marginal Revenue

Revenue from selling an additional unit

What is Marginal Revenue?

Marginal Revenue is the revenue that is gained from the trade of an additional unit. It is a revenue that a company can generate with each additional unit sold; there is a marginal cost attached to it which is to be accounted for.

For example, Mr. A sells 50 packets of homemade chips every day and he incurs some cost to sell and produce them. He determined the price of each packet to be $5, adding all the cost and his profit, where his profit is $1.50 per packet. Now, Mr. A produced 55 packets one day by mistake and took all of them to the market. With no surprise, he was able to sell all 55 packets for $5 each. He made his usual $250 by selling 50 packets in addition to that he sold 5 packets, which were produced by mistake. He was making $1.50 per packet and since he sold 5 additional packets, he made a Marginal Revenue of $7.50 ($1.50 x 5). This is how Marginal Revenue is realized. This is dependent on supply and demand, and on the type of market as well, such as Perfect Competition and Monopoly.

 

 

Marginal Revenue

 

 

In the image above, you can see three curves: Marginal Revenue, Average Revenue or Demand, and Marginal Cost.

 

Marginal Revenue Curve

Let us understand the concept of Marginal Revenue in greater detail. The Marginal Cost curve is a “U” shape curve because the marginal cost for 1-5 additional units will be less and with more incremental units, the marginal cost will begin to rise. The Marginal Revenue curve is sloping downwards because, with one additional unit sold, we would generate revenue close to our normal revenue but as we start selling more and more, we would require reducing the price of the item we are selling. Otherwise, we will not be able to sell it, which is also known as the law of diminishing margin. So, the more you sell after a normal limit, the more the price will diminish and so will the revenue.

 

Average Revenue Curve

There is an Average Revenue curve or Demand curve, which is not the consumers’ demand curve but rather the producers’ demand curve. The curve represents average quantity at an average price. Now that we understand what these curves are and what their function is, let us discuss marginal revenue in the context of marginal cost.

Let us say Mr. X is selling packets of cigarettes, he sells 25 packets every day for $2 each and makes a profit of $0.50 on every pack that he sells. Now, due to an increase in demand, he was able to sell 5 additional packets of cigarettes for the same price. He incurred the same cost, which leaves him with the same amount of profit on these packets as well, which will add up to $2.50 ($0.50 x 5). Mr. X calculated that he could sell even more packs of cigarettes, so he ordered 10 more packs. Now because of government restrictions and limited production, the cost of each pack after the 30th pack increased by 10%, which made the 5 additional packs of cigarettes cost $1.65 each pack. His total cost = (30 packs @ $1.50 = $45 and 5 packs @ $1.65 = $8.25) total cost = $45 + $8.50 = $53.50.

Now he went to the market and tried to sell those cigarette packs for the normal price of $2 each for the first 30 packs and after that, he priced each pack of cigarette for $2.15. He could sell 30 packs easily and was not able to sell remaining 5 packs at the price he determined. In order to sell the remaining packs, he needed to reduce the price to the normal price, otherwise, people would buy them from some other seller. He sold his remaining 5 packs for $2 and could make a diminishing marginal return on those 5 packs. This is how marginal cost and diminishing marginal returns work with the marginal cost taken into account.

In the competitive market or perfect competition, the Marginal Cost will determine the Marginal Revenue and in a monopoly market, the demand and supply would determine the Marginal Revenue.

 

Marginal Revenue Formula

 

Marginal Revenue Formula

 

Marginal Revenue is easy to calculate. All you need to remember is that marginal revenue is the revenue obtained from the additional unit sold. The formula above breaks into two parts: one, change in revenue that means (total revenue – old revenue) and two, change in quantity, which means (total quantity – old quantity).

Example: Mr. A used to sell 10 pencils and now he is selling 15. Earlier, his total revenue was $20 and it is now $28. Putting the values in the formula change in revenue = $8 and change in quantity = 5 pieces, so, $8/5 = $1.60, which is his marginal revenue per additional unit sold.

 

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