How to Calculate Marginal Revenue in Finance: Definition, Formula and Examples
Marginal Revenue Definition
Marginal revenue is the additional revenue a company earns by selling one more unit of a product or service.
Calculating marginal revenue helps businesses to understand the impact of changes in sales volume on revenue.
For example, imagine a subscription service company that introduces a new, lower pricing tier.
The lower subscription price will typically attract more customers and consequently, the increase in the number of subscribers generates additional revenue.
However, the new price also means earning slightly less per subscription.
By evaluating marginal revenue, the company can decide whether the additional revenue from new subscribers outweighs the revenue lost from reducing the price for existing customers.
This can help the company make strategic decisions about pricing and subscription offers to maximize overall revenue.
Marginal Revenue Formula
Calculating marginal revenue uses the formula:
Marginal Revenue = Change in Total Revenue / Change in Quantity
Where:
Change in Total Revenue = Change in total revenue after the increase in the number of units sold
Change in Quantity = Change in the number of units sold.
Calculating Marginal Revenue Step-by-Step
Let’s walk through how to calculate marginal revenue step-by-step:
Step 1: Calculate Total Revenue
Total revenue is calculated by multiplying the price of a product by the quantity sold:
Total Revenue = Price per Unit × Quantity Sold
Step 2: Calculate Change in Total Revenue
To find the change in total revenue, we need to calculate the difference in total revenue before and after an increase in the number of units sold:
Change in Total Revenue = Total Revenue at New Quantity − Total Revenue at Previous Quantity
Step 3: Calculate the Change in Quantity
The change in quantity is the difference between the new quantities and previous quantities sold:
Change in Quantity = New Quantity − Previous Quantity
Step 4: Calculate Marginal Revenue
Using the marginal revenue formula:
Marginal Revenue = Change in Total Revenue / Change in Quantity
Example Marginal Revenue Calculation
Let’s now look at a real world example of the marginal revenue calculation.
Imagine a company that sells handmade candles.
Due to market competition, the company sells more candles when the price per candle decreases.
Initial sales | 10 candles at £20 each |
New sales | 11 candles at £19 each |
Step 1: Calculate Total Revenue
Total Revenue (10 candles): 10 × £20 = £200
Total Revenue (11 candles): 11 × £19 = £209
Step 2: Calculate Change in Total Revenue
Change in Total Revenue = £209 − £200 = £9
Step 3: Calculate Change in Quantity
Change in Quantity = 11 – 10 = 1
Step 4: Calculate Marginal Revenue
Marginal Revenue = £9 / 1 = £9
This means the marginal revenue from selling the 11th candle is £9.
Marginal Revenue in Perfect vs Imperfect Competition
Perfect Competition
In a perfectly competitive market, marginal revenue equals the price of the product.
This is because each additional unit sold does not affect the market price.
For example, if a farmer sells apples at £0.50 each and sells one more apple, the marginal revenue remains £0.50.
Imperfect Competition
In markets with imperfect competition, like monopolies, marginal revenue decreases as more units are sold because the company must lower the price of its product to sell additional units.
For example, a software company reduces the subscription price from £50 to £45 to attract more customers.
The reduction affects both the additional revenue from new customers and the total revenue from existing ones.
Key Points to Remember
Marginal Revenue Can Be Negative
If reducing prices results in lower total revenue, marginal revenue will be negative.
For example, if selling an extra unit decreases the total revenue from £200 to £195, the marginal revenue = −£5
This means that selling an additional unit decreased the total revenue by £5.
In this instance, just focusing on marginal revenue, it is better for the company to have sold less units for a higher price, as more revenue would have been received overall.
Price Elasticity of Demand
Marginal revenue is closely tied to price elasticity of demand.
When demand is elastic, lowering the price can increase total revenue, leading to positive marginal revenue.
On the other hand, inelastic demand may result in negative marginal revenue when prices are reduced.
Marginal Revenue Can Be Zero
Marginal revenue would be zero in situations when selling additional units does not change total revenue, often due to perfectly elastic demand.
Integration with Marginal Cost
Marginal revenue is most useful when analysed alongside marginal cost.
Marginal cost is the additional cost incurred to produce one more unit of a product or service.
Profit is maximised when marginal revenue equals marginal cost (MR = MC).
This is because it is the point where the cost of producing one additional unit matches the revenue it generates.
Beyond this point, profit would decrease due to costs being higher than revenues.