Calculate Marginal Revenue

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According to basic economic principles, if a company lowers the price of the products it sells, it will sell a greater number of products. However, it will also make less money for each additional product it sells. This "extra money" — the revenue generated from selling one additional product — is marginal revenue.

Steps

Calculating Marginal Revenue

  1. Total Revenue = (Current Price Per Product) x (Current Number Products Sold)
  2. Consider lower Alternate Price and determine Alternate Number Products Sold at this price. This step requires specific market analysis.
  3. Alt Revenue = (Alt Price) x (Alt Products Sold).
  4. Marginal Revenue = <math>\frac{Alt Revenue - Original Revenue}{Alt Products Sold - Current Products Sold}</math>.
    • In other words, marginal revenue is the change in revenue per additional product sold.
  5. Example: A company sells 500 T-shirts for $25 each.
    • Total Revenue = $25 x 500 = $12,500
    • The company determines it will sell 530 T-shirts if it drops the price to $24.
    • Alt Revenue = $24 x 530 = $12,720
    • Marginal Revenue = <math>\frac{12720 - 12500}{530 - 500} = \frac{220}{30}</math> ≈ $7.33

Analyzing Marginal Revenue

  1. Start with accurate data. You'll generally need access to a company's internal inventory figures or sales reports to determine the number of products sold. Finding the alternate price to sell one more unit is much more difficult, and requires skill market analysis.
    • Remember, marginal revenue is only useful when analyzing a single product. Some reports may only list data for groups of products.
  2. Avoid negative marginal revenue. A negative marginal revenue means the company would lose revenue if it lowered the price. In this case, selling more products would not make up for the lowered revenue per product.
  3. Compare to marginal cost to determine profitability. Companies that optimize the price/sales balance are said to have a level of output where the marginal revenue equals the marginal cost. Marginal cost is the cost to the company of producing one more unit of product.[1]
    • Marginal Cost = <math>\frac{AltProductionCost - CurrentProductionCost}{AltProductsSold - CurrentProductsSold}</math>.
    • For example, it costs Kim's Soda $50 to produce 200 cans of soda. Kim's could spend $60 instead to produce 225 cans. Marginal cost = <math>\frac{60 - 50}{225 - 200}</math> = $0.40. Kim's soda should only enact this plan if marginal revenue is equal to or greater than $0.40.

Understanding Different Market Structures

  1. Understand marginal revenue under perfect competition. In the examples above, we've been dealing with a simplified market model that considers only one company without competition (a monopoly).[2] More commonly, companies are under pressure to keep prices low due to competition. Under perfect competition, marginal revenue doesn't change as a result of the number of products sold, because prices are fixed.
    • For instance, let's say that Kim's, the soda company from the examples above, is now in competition with hundreds of other soda firms. The price per can is set at $0.50 — any lower and Kim's will lose money, and any higher and customers will choose other products. Marginal revenue is always $0.50, since Kim's cannot sell cans for any other price.
  2. Know the behavior of marginal revenue under monopolistic competition. In real life, the small, competing firms that make up highly competitive markets aren't perfect. They don't instantly react to each others' price changes, they don't have perfect knowledge of their competition, and they don't always set their prices for maximum profitability. This sort of market system is called "monopolistic competition." Marginal revenue will typically decrease with each additional product sold, but not as steeply as it would in a monopoly.
    • For example, Kim's drops the price of its soda from $1 to $0.85. It may still receive additional revenue, but in a monopolistic market, customers will still buy their competitors' soda for a higher price.
  3. Know the behavior of marginal revenue under an oligopoly. In an oligopoly, a few large firms that are in competition with each other control the market. Marginal revenue usually has a downward trend with each additional unit sold, as it would in a monopoly. However, in real life, firms in an oligopoly are often reluctant to lower prices because it can result in a price-dropping war, reducing profits for all.[3] Often, firms in an oligopoly will only lower their prices to force a small competitor out of business, then raise prices together to increase profitability for all.[4] If firms in an oligopoly have agreed to set prices like this, sales levels depend on marketing and other considerations, not on price.
    • Kim's has become a major soda player and now shares the market with Linda's and Andy's, two other soda firms. The three firms agree to sell their sodas at the same price, so marginal revenue for each additional soda will remain unchanged regardless of the price level they chose. If Jeff starts a small firm to undercut their inflated price, the three large firms may drop their prices so low that Jeff is forced out of business. The firms accept the reduced marginal revenue temporarily because they can raise the prices again once Jeff's is gone.

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Sources and Citations

  1. ↑ http://www.amosweb.com/cgi-bin/awb_nav.pl?s=gls&c=dsp&k=marginal%20cost
  2. ↑ http://economics.fundamentalfinance.com/micro_revenue.php
  3. ↑ http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=oligopoly
  4. ↑ http://www.economics.utoronto.ca/jfloyd/modules/olig.html
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