Revenue is the money that a business generates by selling its products and services. A company's profit is equal to its total revenue minus its total costs, so generating revenue is an essential part of running a successful company. "Average revenue" and "marginal revenue" are common terms used in finance and economics. They describe different facets of a firm's revenue.
Average revenue describes the average amount of revenue a firm makes on each unit of a good it sells. For example, if a firm makes 100 T-shirts and sells each one for $10, its average revenue is $10 because each unit of output resulted in $10 of revenue. Average revenue can be calculated by dividing total revenue by the quantity of units sold. Average revenue is also equal to the price level.
Marginal revenue describes the change in total revenue that occurs when a firm produces one extra unit of output. For instance, if a firm produces $100 T-shirts and sells them at a price of $10 each, its total revenue is $1,000. If the firm increases its production to 101 T-shirts, it may have to reduce the price of shirts to entice an extra buyer to purchase the additional unit of output. If the firm drops its price to $9.99 per shirt, its total revenue after selling 101 shirts is $1.008.99. The marginal revenue is $8.99 in this case, because total revenue increased by $8.99 due to producing an extra shirt, while the average revenue changed from $10 to $9.99.
Marginal Cost and Maximizing Profit
Marginal cost is the cost of producing one additional unit of output. In a competitive market, a firm can maximize profit by producing a quantity of goods that makes marginal revenue equal to marginal cost. For example, if a T-shirt company can produce shirts for $5 each, it should continue producing shirts until its marginal revenue equals $5.
As a firm produces more units of a good and reduces its prices to entice buyers to purchase additional units, average revenue decreases because average revenue is equal to the price level. If a firm keeps its prices fixed and is able to sell an additional unit of output without reducing its price, marginal revenue equals average revenue.
Gregory Hamel has been a writer since September 2008 and has also authored three novels. He has a Bachelor of Arts in economics from St. Olaf College. Hamel maintains a blog focused on massive open online courses and computer programming.