Marginal revenue is the additional revenue received by selling one extra unit of a particular product. It is a term synonymous with marginal benefits. Marginal revenues are the revenues earned by producing every extra unit and help to make production decisions. It can be the same or constant until a certain level of production. After that point, it has to decrease as additional units of the product can be sold only after lowering prices. As per the law of demand, an increased supply in the market can only sustain a fall in prices.
In a perfectly competitive market, the marginal revenue or additional revenue generated by the sale of an extra unit of a product is equal to its market price. In such markets, a seller cannot charge extra for any additional unit of the product. It is so because he will lose the customer who will start buying from other sellers. Hence, he will continue selling the product at the market price. Since an individual seller can not change the market price, he will continue to sell until he reaches his marginal cost. So at this stage, his marginal revenue and marginal cost will become the same. Any additional cost incurred to produce one more unit of that product is called the Marginal cost of that product.
In the case of a monopoly, marginal revenue will have a falling trend. That said, additional revenue from every extra sale will continue to go down after a point in time. It is so because the producer will have to decrease prices after a certain level of sales if he wishes to sell more. Thus, a reduction in the price of a product is necessary to generate extra demand.
Marginal Revenue and Marginal Cost
This concept helps the producer to decide the optimum production or output level. A producer continues to produce a product until he covers his marginal cost. It is the point where his marginal revenue is equal to his Marginal cost.
There is further scope for increasing output if the marginal revenue is higher than the marginal cost. The producer will keep on producing until the time he keeps earning more than his cost incurred on every additional unit. If the marginal cost becomes higher than the marginal revenue, it will make no economic sense to keep on producing, and the producer will decrease output. So the point where marginal cost and marginal revenue equals is the optimum or maximum production level. Production and sale beyond this level will mean a loss as the marginal cost will be more than the marginal revenue.
Calculation of Marginal Revenue
The formula for its calculation is:
Change or difference in revenue (Total revenue less Revenue before the last additional unit or units) / Change in quantity (Total quantity less Quantity before the last additional unit or units)
ABC Pvt. Ltd. manufactures chocolates priced at US$ 10 per piece. They presently make 2000 units of chocolates per month. The management decides to increase production and sell 2500 units of chocolates per month. They realize that for doing so, they will have to reduce the rate to US$9 .50 per piece.
= 2500 x US$ 9.50 – 2000 x US$ 10.00 / 2500 – 2000 units
= 23750 – 20000 / 500
=US$ 7.50 per piece
Therefore, the marginal revenue of the additional 500 pieces is US$ 7.50 per piece of chocolate.
Marginal Revenue and the Price Elasticity of Demand
The increase or decrease in the demand for a product, due to a change in its price is the price elasticity of demand. The other variable factors, such as income or change in the taste of a consumer, should be constant. Demand is said to be elastic when a small change in price results in a substantial change in the demand for that product. A slight reduction in the price of a product may see a considerable increase in the demand for that product. Elasticity remains greater than 1 in such a case.
The demand is said to be inelastic when a price change does not result in a shift in demand for that product. It is usually the case with essentials such as petrol. The demand for petrol does not fall much, even with a rise in price. Elasticity is greater than -1 in such cases. The demand is said to be unitary elastic (elasticity=1) when a change in price is precisely proportionate to a shift in demand for that product.
Marginal revenue is related to the price elasticity of demand. If the demand is inelastic, a firm will have to reduce the prices to a considerable extent to sell more of that product. In such a situation, the additional revenue for every extra unit of sale will go on decreasing. So beyond a point, marginal revenue will become negative.
In the case of products with elastic demand, the marginal revenue will be positive. A firm can sell an additional unit of the product with a small reduction in price. In the case of unitary elastic demand, marginal revenue is simply the market price of the product. It is the case in a perfectly competitive market where an individual firm does not influence the price of a product or its quantity sold in the market.