The concepts of Average Revenue (AR) and Marginal Revenue (MR) stand as important metrics and play a role in shaping pricing strategies and influencing the output decisions of firms across various market structures.
Average Revenue represents the revenue generated per unit of output sold, whereas Marginal Revenue represents the additional revenue generated from selling one more unit. Marginal revenue is the change in revenue divide by the change in quantity, while average revenue is total revenue divided by the number of units sold.
What Is Marginal Revenue?
Marginal revenue is the net revenue a business earns by selling an additional unit of its product. As the price of a good is often tied to market supply and demand, a company’s marginal revenue often varies based on how many units it has already sold.
Like other related concepts, marginal revenue can be graphically depicted. It is most often represented as a downward slowing straight line on a chart capturing price on the y-axis and quantity on the x-axis. The downward sloping line represents how a company usually has to decrease its prices to drive additional sales.
While marginal revenue can remain constant over a certain level of output, it follows from the law of diminishing returns and will eventually slow down as the output level increases. In economic theory, perfectly competitive firms continue producing output until marginal revenue equals marginal cost.
In a perfect competition, marginal revenue is most often equal to average revenue. This is because collective market forces make each participant a price-taker.
In an imperfect competition, marginal revenue and average revenue will vary. This is because a firm must eventually lower its price to sell additional units. Both marginal revenue and average revenue tend to be downward sloping with marginal revenue often being the more steeper of the two lines.
Marginal revenue is calculated as the change in revenue divided by the change in quantity for any two given levels of sales. The closer the two levels of sales, the more meaningful and precise the marginal revenue calculation will be.
What Does It Mean If Marginal Revenue Is Negative?
If marginal revenue is negative, this means total revenue falls as additional units are sold. This may be the result of a company needing to cut prices to sell those additional units. In this case, strictly looking at just marginal revenue, it is more ideal for a company to have sold less goods but for a higher average price as more revenue would have been received.
Is Marginal Revenue the Same As Profit?
Marginal revenue only considers income received and does not reflect any marginal expenses required to manufacture or sell the goods. Therefore, marginal revenue is different from profit.
What Is Average Revenue?
Marginal revenue can be analyzed by comparing marginal revenue at varying units against average revenue. Average revenue is simply the total amount of revenue received divided by the total quantity of goods sold.
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.
The Average Revenue helps a firm analyze whether the earnings from producing a unit is decreasing or increasing over a period of time.
The average revenue per unit or user (ARPU) allows a company’s investors or management team to analyze revenue generation capability and forecast future growth. ARPU is a macro-level measurement tool that is useful to analysts and management, but it doesn’t provide much detailed information about the units or user base.
When a company only sells one product at one price, the average revenue of that company’s products is the price of the product. So in many situations, the terms price and average revenue are synonyms. However, when a company sells two or more products at two or more prices, the average revenue is a way to estimate a company’s profits. In this situation, ARPU is essentially the average price of the units or users.
The market structure influences the Average Revenue of a firm. In a perfectly competitive market, the average revenue is equal to the price of a product and the Marginal Revenue, while in a monopolistic or oligopolistic market it is higher than the Marginal Revenue.
Average Revenue (AR): Key Takeaways
Definition
- AR represents the revenue generated per unit of output sold. It is calculated by dividing total revenue by the quantity of output sold.
- Mathematically, AR = Total Revenue / Quantity Sold.
Behavior in Different Market Structures
- In perfect competition, AR is equal to the market price, and it is a horizontal line since the firm can sell any quantity at the given market price.
- In other market structures like monopoly or monopolistic competition, the AR curve is downward-sloping because the firm has to lower the price to sell more units.
Relationship to Demand
- AR is essentially the demand curve faced by the firm in perfect competition.
- In imperfect competition, AR is influenced by the firm’s pricing decisions and elasticity of demand.
Profit Maximization
- In profit maximization, a firm aims to produce where Marginal Cost (MC) equals AR. This is because MR = MC is the condition for profit maximization.
- At the profit-maximizing level of output, AR is equal to the price at which the firm sells its product.
Elasticity
- The elasticity of AR depends on the elasticity of demand. If demand is elastic, a change in price will have a relatively larger impact on quantity, affecting AR accordingly.
Marginal Revenue (MR): Key Takeaways
Definition
- MR is the additional revenue generated from selling one more unit of output.
- Mathematically, MR = Change in Total Revenue / Change in Quantity Sold.
Behavior in Different Market Structures
- In perfect competition, MR is equal to AR, and both are constant.
- In monopolistic competition and monopoly, MR is always below AR, and the MR curve has a steeper slope.
Profit Maximization
- Firms maximize profit where MR equals Marginal Cost (MC). This is the point where the additional revenue from selling one more unit is exactly equal to the additional cost of producing that unit.
Graphical Representation
- In perfect competition, the MR curve coincides with the demand curve and is a horizontal line.
- In imperfect competition, the MR curve is below the demand curve and has a steeper slope.
Relation to Elasticity
- MR is more elastic than AR. This means that a firm must lower its price to sell more units, and as a result, the MR decreases more rapidly than AR.
Average Revenue vs Marginal Revenue
| Criteria | Average Revenue (AR) | Marginal Revenue (MR) |
| Definition | Total revenue divided by the quantity of output sold | The additional revenue generated from selling one more unit of output |
| Formula | AR = Total Revenue / Quantity Sold | MR = Change in Total Revenue / Change in Quantity Sold |
| Relationship to Demand | AR is the demand curve faced by the firm | MR is typically below AR and has a steeper slope |
| Behavior in Perfect Competition | AR equals MR and is constant | MR is always below AR and declines as quantity increases |
| Effect on Revenue | AR remains constant in perfect competition | MR may be constant or changing, depending on market structure |
| Profit Maximization | A firm maximizes profit where MR equals MC (Marginal Cost) | A firm maximizes profit where MR equals MC |
| Elasticity | AR is influenced by price elasticity of demand | MR is more elastic than AR, except in perfect competition where they are equal |
| Graphical Representation | AR is a horizontal line in perfect competition and downward-sloping in other market structures | MR is a downward-sloping line below AR in all market structures |
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