What Is the Difference Between Average and Marginal Revenue?

Revenue generation is a fundamental aspect of any business operation, representing the total income earned from selling goods or services. To effectively manage financial performance and make informed strategic choices, businesses often analyze revenue through different lenses. Understanding these distinct measures provides insights for business analysis.

Understanding Average Revenue

Average revenue (AR) represents the revenue a business earns per unit of output sold. It is calculated by dividing the total revenue generated by the quantity of units sold.

For example, if a company sells 500 units of a product and generates a total revenue of $50,000, the average revenue per unit would be $100 ($50,000 / 500 units). This metric indicates the average price received for each unit sold.

The behavior of average revenue varies depending on the market structure in which a business operates. In a perfectly competitive market, where numerous sellers offer identical products and no single firm can influence market price, average revenue remains constant and equals the market price. This is because each additional unit can be sold at the prevailing market price without affecting it. Conversely, in imperfectly competitive markets, such as monopolies or those with monopolistic competition, the average revenue curve slopes downward. This downward slope indicates that to sell more units, a business must lower its price, which in turn reduces the average revenue per unit.

Understanding Marginal Revenue

Marginal revenue (MR) quantifies the additional revenue generated from selling one more unit of output. It measures the change in total revenue resulting from an incremental change in the quantity sold.

Consider a scenario where a company sells 100 units for $1,000 in total revenue. If selling an additional unit (the 101st unit) increases total revenue to $1,045, the marginal revenue for that 101st unit is $45 ($1,045 – $1000) / (101 – 100). This figure reflects the revenue impact of producing and selling an additional unit.

In a perfectly competitive market, marginal revenue is constant and equal to both the market price and average revenue. This occurs because a firm can sell any quantity at the established market price. However, in imperfectly competitive markets, marginal revenue behaves differently. It is less than average revenue and declines at a faster rate as more units are sold.

Comparing Average and Marginal Revenue

While both average revenue and marginal revenue are important for understanding a business’s sales performance, they provide different perspectives on revenue generation. Average revenue shows the per-unit revenue, the average price at which all units are sold. Marginal revenue reveals the specific revenue gained from selling an incremental unit.

In a graphical representation, particularly in imperfect competition, the marginal revenue curve lies below the average revenue curve and exhibits a steeper downward slope. As a business sells more units and its average revenue falls, its marginal revenue falls even more rapidly. The total revenue a business earns reaches its maximum point when marginal revenue falls to zero. Beyond this point, if marginal revenue becomes negative, total revenue begins to decrease.

The relationship between these two revenue measures has specific implications for a business. When marginal revenue is equal to average revenue, it indicates that the average revenue is constant, a characteristic of perfect competition where price does not change with quantity sold. However, in situations where average revenue is decreasing, marginal revenue will always be less than average revenue. In real-world markets, businesses must lower prices to stimulate additional sales.

Marginal revenue declines faster than average revenue in real-world scenarios, particularly in imperfect competition, due to pricing strategy. To sell an additional unit, a firm needs to reduce the price not only for that extra unit but for all units sold. The price reduction on previously sold units means that the incremental revenue from the new sale is offset by the lower revenue received for all other units, causing marginal revenue to fall more steeply than the average.

Applying Revenue Concepts to Business Decisions

The understanding of average and marginal revenue, and their relationship, provides a framework for making informed business decisions regarding pricing, production levels, and profit maximization. Businesses use these concepts as analytical tools to gauge the financial implications of increasing or decreasing output, serving as inputs for strategic analysis.

Profit maximization involves the interplay between marginal revenue and marginal cost (MC). Profit maximization occurs at the output level where marginal revenue equals marginal cost. If marginal revenue exceeds marginal cost, producing an additional unit adds more to revenue than to cost, thereby increasing total profit.

Conversely, if marginal cost surpasses marginal revenue, producing more units would reduce overall profit. This quantity represents the optimal production level for profit. Average revenue then helps determine the price at which that optimal output can be sold.

Average revenue offers insight into the average price per unit, useful for general financial performance assessment. Marginal revenue, however, provides a more granular view, indicating the profitability of selling one more unit. This distinction guides decisions on whether to expand or contract production.

For instance, if marginal revenue is positive and exceeds marginal cost, expanding production could lead to increased profits. Conversely, if marginal revenue is low or negative, and falls below marginal cost, scaling back production might be necessary to prevent losses. Marginal analysis, which considers these incremental changes, is a forward-looking approach that supports business adjustments.