Businesses of all sizes, including small businesses, can benefit from a basic understanding of specific economic concepts. Beyond the basic concepts of supply and demand, a small business owner must understand related concepts, specifically marginal revenue. A thorough understanding of marginal revenue can help decision-makers within the business make informed decisions concerning changes in production.
Marginal Revenue Basics
Marginal revenue is an economic concept that helps analyze the potential benefits and consequences associated with ramping up production. Specifically, marginal revenue measures the additional benefit, or revenue, gained from producing an additional unit of product. It is equal to the change in total revenue divided by the change in quantity. Thus, small business owners should pay particular attention to marginal revenue, as the results could have a significant impact on the bottom line.
Only in a perfectly competitive market will the marginal revenue equal the price of the product at all output levels. Perfectly competitive markets don't exist; they serve as a benchmark for economists to measure the difference between ideal situations and actual market conditions. In a perfectly competitive market, firms are price-takers, meaning the firm can sell all it wishes to sell at a given price. Because of this, price decreases are not necessary to spur additional sales.
Other market types, such as oligopoly, monopoly, and monopolistic competition, will witness a decrease in marginal revenue as production increases. This is because a reduction in price is often necessary to spur additional sales beyond the traditional demand seen for the product. The decrease in price will result in a decrease in total revenue, thus leading to a decrease in marginal revenue. At some point, marginal revenue will approach zero and can even become negative.
Marginal cost is another important concept to understand when analyzing the benefits of marginal revenue. Firms must base production decisions on both marginal revenue and marginal cost. Ideally, profit is maximized when marginal revenue equals marginal cost. At this point, the firm is receiving all possible profits from production and preventing a situation that results in revenue loss.
- Photos.com/Photos.com/Getty Images