Marginal revenue and marginal benefits can help companies determine how much of a product to produce in order to maximize profits. Marginal benefit is a measure of a consumer's benefit of purchasing an additional unit of a good or service, while marginal revenue is a measure of how much money a company earns by producing a unit of a good or service.
Marginal benefit measures the incremental increase in benefit to a consumer achieved by consuming one additional unit of a good or service. Another way to think of marginal benefit is the maximum amount a consumer is willing to pay in order to consume that additional unit. In a typical situation, marginal benefit will decline as the consumption of a good or service increases.
Let's say a consumer wishes to purchase an additional pair of shoes. If that consumer is willing to pay $50 for that additional pair, then the marginal benefit of that purchase is $50. However, the more pairs of shoes that consumer has, the less he or she will want to pay for the next one. This is because the benefit of owning an extra pair of shoes decreases as the consumer accumulates more and more shoes.
Marginal revenue is the increase in revenue generated from selling one additional unit of a good or service. Marginal revenue is calculated by dividing the change in total revenue by the change in quantity sold. The change in total revenue is calculated by subtracting the revenue before the last unit was sold from the total revenue after the last unit was sold.
Let's say a company manufactures space heaters and brings in $20 in revenue by producing its first heater. In this case, its marginal revenue would be $20 ($20 in revenue/1 unit). Now let's say that company produces a second heater and brings in $15 in revenue. The marginal revenue gained by producing that additional unit is $15 ($35-$20 = $15 change in revenue/1 additional unit).
While marginal revenue can remain steady over a certain level of output, it tends to diminish as a company produces more units of a given product. Companies can maximize their profits by making sure that the cost of producing an additional unit does not exceed the additional revenue gained by selling that unit.
Marginal revenue and monopolies
In a competitive market, marginal revenue may not be all that remarkable. In a monopoly, on the other hand, the marginal revenue a company gains from selling an additional unit will always be less than the price that unit is sold for. In a monopoly, one company is able to control overall production for a given product. However, to sell an additional unit, the company that has the monopoly must decrease the price for all units sold and thus lose out on revenue.
Let's say there's a single company that produces flying cars and sells them for $500,000 apiece, and that this company sells one car in its first week of operation and brings in $500,000 in revenue. In this case, its marginal revenue would be $500,000 ($500,000 in revenue/1 unit).
Now let's say that same company reduces the price of the flying car to $400,000 to sell more units, and is able to sell one more unit immediately. The marginal revenue for the additional unit is $400,000 ($900,000-$500,000 = $400,000 change in revenue/1 additional unit). If the $400,000 price point compels more consumers to purchase flying cars, as the company sells more units for $400,000, its marginal revenue will decrease from when it sold its first flying car.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!