In essence, calculating marginal revenue is a simple matter of applying a formula wherein changes in total revenues are divided by changes in quantities sold. What is important for business owners, managers and analysts to understand is under what conditions should marginal revenue be considered.
In theory, marginal revenue is realized when an additional unit of a good or service is sold. When a scenario of perfect market conditions is applied to marginal revenue, we can see a constant figure as long as the output is maintained; however, once diminishing returns are considered, marginal revenue will be reduced by an increase in output.
Marginal revenue can be useful to consider for businesses involved in manufacturing or assembly. Let’s say, for example, that a company that puts together and sells MP3 players is forced to completely stop production. Under this assumption, the revenue could be $0.00 if there is no stock to sell. Once the company resumes production and manages to sell one MP3 player for $30, the marginal revenue will then be $30. If the company decides to lower the sales price to $20 for the second MP3 player, the marginal revenue is $10 since ($30-$20) divided by one extra MP3 player equals $10.
In practical business situations, marginal revenue calculations can help illustrate why homogenous pricing is not always a smart policy to follow. Competition is the cornerstone of all business activity; to this effect, the marginal revenues of companies dictate the market price since they are based on the last goods sold or services offered. For monopolies or companies that are absolute leaders in niche markets, marginal revenue tends to be flat until competitors arrive.
Calculating marginal revenue can also help business owners and managers to reach situations whereby their marginal cost is equal to its revenue counterpart, which creates opportunities for profit maximization expressed as the marginal revenue subtracted from the marginal cost. When marginal profit is positive, total profits increase.
Economic theories of marginal revenue are better suited to good than services, and they fall considerably short when considering salaries. If wages are considered to be the marginal revenue product that an individual should enjoy due to his or her contribution to society, how can we being to explain the conundrum of school teachers and their meager salaries? Once again, we run into the fallacy of perfect market conditions, which are hardly ever experienced in real life.