What Is the Relationship Between Marginal Revenue and Total Revenue?

Total revenue is the amount of money that a business brings in by selling its goods or services at a given price. It is the starting point of a company’s income statement, which determines how much net income it makes after expenses, taxes, and interest are taken into consideration. As such, it’s one of the most important line items for a business.

There are many ways to look at the money that a business earns. Total revenue is one; another is marginal revenue, which refers to the increase in money earned by selling one additional unit of a product or service.

Key Takeaways

• Total revenue is the amount of money a company earns by selling products and services at a certain price.
• Total revenue is calculated by multiplying the total amount of goods and services sold by their prices.
• Marginal revenue is the increase in money earned from selling one additional unit of a good or service.
• Companies continue producing and selling more goods and services until marginal revenue equals marginal cost.

Total Revenue vs. Marginal Revenue

As noted above, total revenue is the total amount of sales of goods and services. It is calculated by multiplying the total amount of goods and services sold by their price. Marginal revenue is directly related to total revenue because it measures the increase in money made from selling one additional unit of a good or service.

Total revenue is important because businesses strive to maximize the difference between their total revenues and total costs as they try to grow profits. Understanding the subtleties of the relationship between revenues and costs distinguishes the better business managers from the lesser ones. This is because while increasing production generally leads to an increase in sales and total revenue, there are also costs involved. 

Marginal revenue is important because it measures increases in total revenue from selling more products and services. Marginal revenue follows the law of diminishing returns, which predicts that after some optimal level of production capacity is reached, adding an additional factor of production will actually result in smaller increases in revenue.

It costs money to make and sell an additional unit. As long as marginal revenue is above or equal to marginal cost, a company is making a profit. Once marginal cost exceeds marginal revenue, it makes no sense for a company to produce or sell more units of its products or services, as it would effectively be losing money with each unit.

Important

There is a direct relationship between marginal revenue and the price elasticity of demand. This is the change in consumption of goods and services based on their prices. Positive marginal revenue means demand is elastic. When marginal revenue is negative, demand is inelastic.

Law of Diminishing Marginal Returns

As noted above, marginal revenue adheres to the economic theory of the law of diminishing returns. According to this rule, any additional factors of production may lead to a drop in revenue. This is because workers and the manufacturing process end up reaching their peak or optimal level. Put simply, factoring in one additional unit of production will have a negative impact on the returns related to per-unit increases—even if they’re incremental ones.

This can be visualized in a concave chart. The total revenue earned from aggregate unit production rises only to plateau once the optimal level of production is achieved. At some point it may even start to fall. As there is a positive correlation between these two types of revenue, total revenue drops when marginal revenue does.

Based on the law of diminishing marginal returns, companies need to find the right balance when it comes to production levels. Doing so can help them maintain both total and marginal revenue.

How Businesses Can Use Total Revenue and Marginal Revenue

Businesses, analysts, and investors can use total and marginal revenue to determine the competitiveness and success of companies. Both types of revenue have a direct relationship to corporate income. Companies that are successful often have consistent total and marginal revenues.

In order to remain competitive, companies must be able and willing to increase production—but only to a certain extent. As we already know that reaching optimal levels can lead to a drop in returns, companies must regularly monitor production levels. A cost-benefit analysis is usually required once marginal production costs begin to exceed marginal revenue.

Example of Total Revenue and Marginal Revenue

Calculating Total Revenue

The calculation of total revenue frequently takes timetables into account. For instance, a restaurateur may tabulate the number of hamburgers sold in an hour or the number of orders of medium-sized french fries sold in a business day. In the latter case, if 300 orders of fries were sold at $2 per order, the total daily revenue would be $600.

However, consider what happens if the restaurateur drops the price of a unit of french fries to $1.50 and heavily advertises the new discounted price. This could result in a bump in sales—let’s say to 500 units per day. Consequently, the total daily revenue changes to $750. This sounds like an improvement. However, if the cost of the additional advertising is high enough, it could reduce the $750 to the point where it’s not as good as earning $600 while not incurring that extra cost.

Total revenue changes with respect to price, and quantity can be visually demonstrated on a graph, in which a demand curve is drawn that signals the balance of price and quantity that would maximize total revenue.

Calculating Marginal Revenue

To calculate marginal revenue, divide the change in total revenue by the change in the quantity sold. Therefore, the marginal revenue is the slope of the total revenue curve.

Marginal Revenue = Change in Total Revenue ÷ Change in Quantity Sold

Let’s go back to the example from above. Suppose the company sells one unit of fries for a price of $2 for each of its first 300 units. Its total revenue would be $600 (300 x 2). The company sells the next 500 units of fries for $1.50 each. Its total revenue would be $1,350 ($600 + [500 x 1.50]).

Suppose the company wanted to find the marginal revenue gained from selling its 301st unit. The total revenue is directly related to this calculation. First, the company must find the change in total revenue, which in this case is $1.50 ($601.50 – $600). Next, it must find the change in the number of orders of fries sold, which is 1 (301 – 300). Thus, the marginal revenue gained by producing the 301st unit of fries is $1.50 ($1.50 ÷ 1).

Now suppose the company decides to mark the price down further, to $1 per unit, advertises even more heavily, and wants to find its marginal revenue gained from selling its 801st unit. The change in total revenue is now $1 ($1,351 – $1,350), while the change in the number of orders of fries sold remains 1 (801 – 800). Thus, marginal revenue has dropped to $1 ($1 ÷ 1).

As marginal revenue decreases with the unit price, it must be compared with the marginal cost of producing a unit. In this case, if the rise in advertising costs have outpaced the drop in price too much, marginal cost will outweigh marginal revenue.

Is Marginal Revenue a Derivative of Total Revenue?

Yes, it is, at least when it comes to demand. This is because marginal revenue is the change in total revenue when one additional good or service is produced. You can calculate marginal revenue by dividing total revenue by the change in the number of goods and services sold.

Does Marginal Revenue Increase if Total Revenue Increases?

There is a positive correlation between marginal and total revenue. This means that when total revenue increases, marginal revenue is positive. When total revenue falls, however, you can end up with negative marginal revenue.

What Is the Difference Between Marginal Cost and Marginal Revenue?

Marginal cost is the extra expense a business incurs when producing one additional product or service. Marginal revenue, on the other hand, is the incremental increase in revenue that a business experiences after producing one more product or service. Adjustments to a company’s marginal revenue may be made due to a change in its marginal cost. A company’s production reaches its optimal point when marginal cost and revenue are equal.

The Bottom Line

Total revenue is the amount of money a company is making from selling its goods and services. It determines how well a company is bringing in money from its core operations based on demand and price.

Marginal revenue measures the increase in revenues from selling an additional unit of a good or service, which helps management determine if it should produce and sell more. Once the marginal cost of producing an extra unit is greater than the marginal revenue, a company will halt production, as it is not making profits on the additional units sold.