Marginal revenue and marginal cost are essential calculations that help companies analyze and maximize their profits. Taken together, marginal revenue and marginal cost are used to determine how many units of a given product or service a company should produce, as well as the price per unit.
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Marginal revenue is the increase in revenue that's generated by selling one additional unit of a good or service. Marginal revenue is calculated by dividing the change in total revenue by the change in the number of units sold. The change in total revenue is calculated by subtracting the revenue before the last unit was sold from the total revenue after it was sold.
Let's say a company brings in $40 in revenue by producing its first unit. Initially, its marginal revenue will be $40 ($40 in revenue/1 unit). If that company produces a second unit and brings in another $30 in revenue for a total of $70, then its marginal revenue gained from that additional unit is $30:
$70 - $40 = $30 change in revenue
$30/1 additional unit = $30 marginal revenue
Marginal cost is the increase in cost a company incurs by producing one extra unit of a good or service. Marginal cost is calculated by taking the change in cost and dividing it by the change in quantity.
Let's say the cost for a company to produce 10,000 units of a given product or service is $50,000, and the cost to produce 10,001 units is $50,003. In this case, the marginal cost for that additional unit is $3:
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change in costs = $50,003 - $50,000 = $3
$3/change in quantity = $3/(10,001 - 10,000) = $3 marginal cost
In this case, the marginal cost to produce one extra unit is lower than the average cost per unit to produce the previous 10,000, which is $5:
$50,000/10,000 units = $5 per unit
Because certain costs of doing business, such as salaries and rent, can remain constant up to a certain level of output, it is often the case that the marginal cost of producing additional units is lower than the initial cost of producing them.
When output increases
If a company's marginal revenue is less than the marginal cost of producing more units, it's an indication that the company is producing too much. On the other hand, if a company's marginal revenue is greater than its marginal cost, it indicates that the company is not producing enough units. When a company's marginal revenue equals its marginal cost, it's in the best position to maximize its profits.
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