Marginal revenue is defined as the revenue gained by producing one more unit of a product or service. Therefore, it is sometimes also referred to as the revenue of the last unit. In economics, the concept of marginal revenue is very important because it helps firms to make efficient production decisions and maximize profits by comparing additional costs and revenue. We have explained how to calculate marginal cost in an earlier article. Thus, in the following paragraphs you will learn how to calculate marginal revenue. To do this, we can follow a simple three-step process: (1) calculate change in revenue, (2) calculate change in quantity, and (3) divide change in revenue by change in quantity.
1) Calculate Change in Revenue
First of all, we have to compute the change in revenue. Usually, when the level of output increases or decreases, revenue rises or falls accordingly. That means, as a rule of thumb more output results in higher revenue, whereas less output results in lower revenue. Calculating the change in revenue is easy. All we need to do is take the revenue after a given change in output (i.e. new revenue) and subtract that from the revenue before the change (i.e. old revenue). This leaves us with the following formula:
Change in revenue = New revenue – old revenue
Let’s look at an example. Say you own an ice cream shop; Ice Cream Wonderland. Yesterday, you sold a total of 200 ice cream cones at a price of USD 2.00 each. That means, your total revenue was USD 400 (200*2.00). Today you manage to sell 220 cones at the same price. As a result, your total revenue increases to USD 440 (220*2.00). Hence, the change in revenue from yesterday to today amounts to USD 40 (440 – 400).
2) Calculate Change in Quantity
Next, we need to compute the change in quantity. In most cases, we assume that an increase in the level of output results in an equally large rise in the quantity sold. In that case, the change in quantity is identical to the change in output. Only in some cases the two numbers don’t match. Specifically, when the increase in output surpasses demand, it will not be possible to sell all additional units. Instead, some of them won’t be sold but stored in an inventory. This results in an increase in revenue that is smaller than the increase in output. However, as mentioned above, in most cases you can assume that all additional output can be sold. To calculate the actual change in quantity, we take the quantity after the change in output (i.e. new quantity) and subtract it from the quantity before the change (i.e. old quantity). This leaves us with the following formula:
Change in Quantity = New quantity – old quantity
Let’s revisit our example. The quantity of ice cream produced (and sold) increased from 200 cones yesterday to 220 cones today. Thus, it has increased by 20 ice cream cones (220 – 200). Please note, even though marginal revenue is defined as the additional revenue gained by producing (and selling) one more unit of a good or service, we can still calculate it for any given number of additional units.
3) Divide Change in Revenue by Change in Quantity
Now we can finally calculate marginal revenue by dividing the change in revenue by the change in quantity. If you look at the definition of marginal revenue from above – the revenue gained by producing one more unit of output –you can easily see why we divide the change in revenue by the change in quantity; we want to calculate the increase in revenue per additional unit. At this point it is important to point out that marginal revenue can change across different levels of output. That is, if quantity changes from 1 to 2 units, it may differ significantly from the marginal revenue of producing 101 instead of 100 units. But don’t worry, we can always use the following formula to calculate it:
Marginal revenue = change in revenue / change in quantity
In the case of Ice Cream Wonderland we can calculate marginal revenue as follows. We divide USD 40 (i.e. change in revenue) by 20 cones (i.e. change in quantity). Thus, at the current level of output, marginal revenue equals USD 2.00 per ice cream cone.
In a Nutshell
Marginal revenue is defined as the revenue gained by producing one more unit of a product or service. This is important because it helps firms to make efficient production decisions and maximize profits. To calculate marginal revenue, we can follow a simple three-step process: (1) calculate change in revenue, (2) calculate change in quantity, and (3) divide change in revenue by change in quantity.