Understanding the Key Difference Between Marginal Cost and Marginal Revenue

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:

• 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.

• 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.

• On a graph, marginal cost is typically a U-shaped curve that eventually slopes upward. Marginal revenue is typically a downward sloping line.

• Marginal cost is based on internal factors like labor, materials, facilities. Marginal revenue depends on external market forces of supply and demand.

• 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:

• 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.

• 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.

• 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.