The marginal cost of production and marginal revenue are economic measures used to determine the amount of output and the price per unit of a product that will maximize profits.
A rational company always seeks to squeeze out as much profit as it can, and the relationship between marginal revenue and the marginal cost of production helps them to identify the point at which this occurs. The target, in this case, is for marginal revenue to equal marginal cost.
Marginal cost and marginal revenue are two important concepts in economics and business that relate to how much it costs a company to produce an additional unit of a product versus how much additional revenue that extra unit brings in. There is a key difference between these two ideas that business managers need to understand in order to make profitable decisions. In this article we will explain marginal cost and marginal revenue in simple terms and illustrate the key differences between them using clear examples.
What is Marginal Cost?
Marginal cost represents the additional cost incurred by a company to produce one more unit of a product. For example, let’s say a restaurant sells pizza. If they make 10 pizzas in an hour, the total cost might be $100 including ingredients labor electricity for the oven, etc. If they make 11 pizzas in that hour instead, the total cost goes up to $105. So the marginal cost of producing that 11th pizza is $5.
In economic terms, marginal cost is the derivative of the total cost function. It describes the rate of change in total costs whenever production volume changes. Marginal cost typically increases as production goes up because companies have to invest more to produce at larger scales – buying more raw materials, paying workers overtime, etc.
However, initially, marginal costs may decrease before increasing. For example, fixed costs like equipment and facilities are distributed over more units. But eventually marginal costs start going up again as factories hit capacity limits.
What is Marginal Revenue?
Marginal revenue represents the additional income gained by a company from selling one more unit of a product. Let’s go back to the pizza example. If the restaurant sells 10 pizzas for $100 total revenue, and then sells 11 pizzas for $110 total revenue, the marginal revenue from the 11th pizza is $10.
In economic terms, marginal revenue is the derivative of the total revenue function. It describes the rate of change in total revenue whenever the sales volume changes. For competitive companies, marginal revenue typically decreases as production increases because the company has to lower prices to sell more.
For example, the restaurant may charge $15 per pizza if they only make a few. But if they want to sell 100 pizzas, they may lower the price to $10 per pizza to attract more demand. So marginal revenue declines as volume increases. This gives marginal revenue a downward sloping curve on a graph versus quantity.
Key Differences Between Marginal Cost and Marginal Revenue
Now that we have defined both concepts, let’s summarize the key differences:
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Marginal cost focuses on the production side of the business and looks at how much it costs to make each additional unit. Marginal revenue looks at the market side and how much selling an extra unit brings in revenue.
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Marginal cost tends to increase over time as production scales up. Marginal revenue tends to decrease over time as companies sell more units by lowering prices.
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On a graph, marginal cost is typically a U-shaped curve that eventually slopes upward. Marginal revenue is typically a downward sloping line.
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Marginal cost is based on internal factors like labor, materials, facilities. Marginal revenue depends on external market forces of supply and demand.
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Marginal cost can be controlled to some degree by improving production efficiency. Marginal revenue is dictated by competitive pressures in the overall market.
Why Understanding Marginal Cost vs. Revenue Matters
Looking at marginal cost and marginal revenue allows companies to make better decisions about manufacturing, pricing, and profits. For example, production should increase until marginal revenue equals marginal cost. Up to that point, marginal revenue exceeds marginal cost so producing more units adds to profitability. Beyond that point, marginal cost is higher than marginal revenue so profits would decline by making more.
By analyzing marginal economics, managers can determine optimal production volumes, efficient pricing levels, and strategies for maximizing profits. The concepts also explain why competitive companies earn zero economic profit in the long run. Marginal revenue gets driven down to minimum average cost by competition.
Real World Examples
Let’s look at some numerical examples to further illustrate the difference between marginal cost and marginal revenue:
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Company A sells widgets for $10 each. Their fixed costs are $100 and they have no variable costs. If they sell 10 widgets, total revenue is $100. If they sell 11 widgets, total revenue is $110. So the marginal revenue from the 11th unit is $10. Marginal cost is zero since there are no variable costs.
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Company B also sells widgets for $10 each. They have $100 fixed costs. Their variable costs are $5 per widget. If they sell 10 widgets, total cost is $150. If they sell 11 widgets, total cost is $155. So the marginal cost to make the 11th widget is $5. Marginal revenue is still $10 per widget.
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Company C lowers widget prices to $8 each to sell more volume. At 100 widgets sold, revenue is $800. At 101 widgets sold, revenue is $808. Marginal revenue per unit is now only $8. Their marginal cost per unit remains unchanged.
As you can see, marginal revenue declines as Company C sells more units thanks to lower prices. But their marginal cost stays fixed. These dynamics impact the profitability of each additional widget sold.
A Graphical Example
Let’s look at one more example using supply and demand curves:
![Marginal cost and revenue graph][]
In this graph, the supply curve represents marginal cost while the demand curve represents marginal revenue. The optimal quantity to produce and sell is where MC = MR, which is 80 units in this example. Up to 80 units, marginal revenue exceeds marginal cost so profits increase by producing more. Beyond 80 units, marginal costs are higher than marginal revenue, so profits would decrease with further production.
This visual reinforces the economic logic behind looking at marginal data. Companies need to determine the break-even points where marginal economics flip and reductions in price to drive sales become unprofitable due to marginal costs.
Key Takeaways on Marginal Cost vs. Marginal Revenue
- Marginal cost represents the incremental cost to produce additional units, while marginal revenue represents the extra revenue earned from selling additional units.
- Marginal cost typically increases as production ramps up, while marginal revenue decreases when companies sell more units through discounts and lower prices.
- Analyzing marginal data helps companies maximize profits by finding the optimal quantity where marginal revenue equals marginal cost.
- The divergence between marginal cost and marginal revenue explains why competitive firms struggle to earn sustained profits over the long run.
Understanding the divergence between rising marginal costs and falling marginal revenues provides powerful insights into production planning, pricing policies, and profit maximization strategies. Managers should continually analyze marginal data points as they make decisions to optimize their company’s economic performance.
Marginal Analysis
All these calculations are part of a technique called marginal analysis, which breaks down inputs into measurable units. First developed by economists in the 1870s, it gradually became part of business management, especially in the application of the cost-benefit method—the identification of when marginal revenue is greater than marginal cost, as weve been explaining above.
According to the cost-benefit analysis, a company should continue to increase production until marginal revenue is equal to marginal cost. If the optimal output is where the marginal benefit is equal to the marginal cost, any other cost is irrelevant. So marginal analysis also tells managers what not to consider when making decisions about future resource allocation: They should ignore average costs, fixed costs, and sunk costs.
For example, a toy manufacturer could try to measure and compare the costs of producing one extra toy with the projected revenue from its sale. Suppose that, on average, it costs the company $10 to make a toy. The average sales price over the same period is $15.
This doesnt necessarily mean that more toys should be manufactured, however. If 1,000 toys were previously manufactured, then the company should only consider the cost and benefit of the 1,001st toy. If it will cost $12.50 to make the 1,001st toy but will only sell for $12.49, the company should stop production at 1,000.
What Is Marginal Cost and Average Cost?
Marginal cost is the expense to make any given one incremental unit. On the other hand, average cost is the total cost of all units divided by the number of units manufactured. Be mindful that marginal cost does not always equal average cost.
How Much to Produce? The Story of Marginal Revenue and Marginal Costs
What is the difference between marginal cost and marginal revenue?
Marginal cost is the money paid for producing one more unit of a good. Marginal revenue is the money earned from selling one more unit of a good. The Davis family grows organic vegetables to sell at a local farmer’s market. Which are factors that directly affect their profit?
What if marginal cost is greater than marginal cost?
Marginal cost is the cost of selling one more unit. If marginal revenue were greater than marginal cost, then that would mean selling one more unit would bring in more revenue than it would cost. If that is the case, then why would you not sell that additional unit?
What happens if marginal revenue falls below marginal cost?
When marginal revenue falls below marginal cost, firms typically do a cost-benefit analysis and halt production as it may cost more to sell a unit than the company will receive as revenue. Marginal revenue is a financial and economic calculation that determines how much revenue a company earns for each additional unit sold.
Does marginal revenue increase or decrease?
According to the chart, the marginal revenue remains the same as production increases. Producers often work to maximize their ____ and make them as large as possible. To generate higher profit margins, producers must work to decrease their production costs. What is the difference between marginal cost and marginal revenue?