Marginal Revenue

How do you know how well a company is operating? What does it mean for a company to have had a billion pounds in total revenue in a single year? What does that mean for the company’s average revenue and marginal revenue? What do these concepts mean in economics, and how do firms use them in their day-to-day business operations?

This explanation will teach you what you need to know about total revenue, average revenue, and marginal revenue.

Total revenue

To understand the meaning of marginal and average revenue, you have to start by understanding the meaning of total revenue.

The total revenue doesn’t take into account the cost that the firm incurs during a production process. Instead, it only takes into account the money coming from selling what the firm produces. As the name suggests, total revenue is all the money coming into the firm from selling its products. Any additional unit of output sold would increase the total revenue.

Average revenue

Average revenue shows how much revenue there is per unit of output. In other words, it calculates how much revenue a firm receives, on average, from each unit of product they sell. To calculate the average revenue, you have to take the total revenue and divide it by the number of output units.

Marginal revenue

Marginal revenue refers to the increase in total revenue from increasing one output unit. To calculate the marginal revenue, you have to take the difference in total revenue and divide it by the difference in total output.

Figure 1. illustrates the three types of revenue.

Why is the average revenue the firm’s demand curve?

The average revenue curve is also the firm’s demand curve. Let's see why.

Figure 2. Average Revenue and the Demand Curve, StudySmarter Originals

Figure 1 above illustrates how the demand curve for the firm’s output equals the average revenue a firm experiences. Imagine there’s a firm that sells chocolate. What do you think would happen when the firm charges £6 per chocolate?

By charging £6 per unit of chocolate the firm can sell 30 units of chocolate. That suggests that the firm makes £6 per chocolate sold. The firm then decides to decrease the price to £2 per chocolate, and the number of chocolates it sells at this price increases to 50.

Note that the amount of sales at each price is equal to the firm’s average revenue. As the demand curve also shows the average revenue the firm makes at each price level, the demand curve equals the firm’s average revenue.

You can also calculate the firm’s total revenue by simply multiplying the quantity by the price. When the price equals £6, the quantity demanded is 20 units. Therefore, the firm's total revenue is equal to £120.

The relationship between marginal and total revenue

Total revenue refers to the total sales a firm experiences from selling its output. In contrast, the marginal revenue calculates how much the total revenue increases by when an additional unit of goods or services is sold.

Total revenue is extremely important for firms: they always try to increase it as it would result in an increase in profits. But an increase in total revenue doesn’t always lead to profit maximisation.

Sometimes, an increase in total revenue can be harmful to a firm. The increase in revenue could decrease productivity or increase the cost associated with producing the output to generate sales. That’s when the situation becomes complex for firms.

The relationship between total revenue and marginal revenue is important because it helps firms make better decisions when profit maximising. Remember that marginal revenue calculates the increase in total revenue when additional output is sold. Although, initially, marginal revenue from selling an additional unit of a product continues increasing, there comes the point where the marginal revenue starts to fall due to the law of diminishing marginal returns. This point where the diminishing marginal returns kick in is shown at point B in Figure 2 below. This is the point at which total revenue is maximised and marginal revenue is equal to zero.

After that point, although the total revenue of a firm is increasing, it increases by less and less. This is because an additional output sold is not adding as much to the total revenue after that point.

Figure 3. Relationship between marginal and total revenue, StudySmarter OriginalsAll in all, as the marginal revenue measures the increase in total revenue from selling an additional unit of output, it helps firms decide whether it’s wise to increase their total sales by producing more.

The relationship between marginal and average revenue

The relationship between marginal revenue and average revenue can be contrasted between the two opposite market structures: perfect competition and monopoly.

In perfect competition, there is a huge number of firms supplying goods and services that are homogenous. As a result, firms can’t influence the market price as even the slightest increase would lead to no demand for their product. This means that there is perfectly elastic demand for their product. Due to the perfectly elastic demand, the rate at which total revenue increases is constant.

Since the price remains constant, an additional product sold will always increase the total sales by the same amount. Marginal revenue shows how much total revenue increases as a result of an additional unit sold. As total revenues increase at a constant rate, the marginal revenue will be constant. Additionally, average revenue shows the revenue per product sold, which is also constant. This leads to marginal revenue being equal to the average revenue in a perfectly competitive market structure (Figure 4).

In contrast, in an imperfectly competitive market structure, such as a monopoly, you can observe a different relationship between average revenue and marginal revenue. In such a market, a firm faces a downward-sloping demand curve equal to average revenue in Figure 2. The marginal revenue will always be equal to or smaller than the average revenue in an imperfectly competitive market (Figure 5). That’s due to the change in output sold when prices change.