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Marginal revenue (MR) represents the increase in revenue from the sale of one additional product or service. Although marginal revenue can be constant over many units of output, the law of diminishing returns states that it will eventually decrease as the output level increases.
Knowing your marginal revenue is particularly important in competitive markets because, according to economic theory, profit maximization results from continuing to produce more units of output until marginal revenue equals marginal cost.
In this article, we will go through the theory behind marginal revenue, explain why it is important for production decisions, compare it to some similar metrics, and discuss the analysis of marginal revenue.
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Understanding marginal revenue
While marginal revenue in an economics classroom is usually considered the amount of added revenue gained by selling one more unit of production, in practice this isn’t reasonable because firms are rarely in the position to sell a single extra item. Instead, marginal revenue is usually thought of as the total change in revenue divided by the total change in output.
An example of the classroom version is as follows: a SaaS enterprise sells 100 subscriptions for $1000. They then sell their 101st subscription for $7. Therefore, their marginal revenue is $7.
An example of the more realistic latter situation is as follows: a SaaS enterprise sells 100 subscriptions for $1000. They then start a 30% discount pricing campaign and sell 50 more subscriptions for $350 total. Since 350/50 = 7, the marginal revenue of the discounted batch of service agreements is $7.
Marginal revenue only regards the most recent unit or set of units. Conversely, average revenue is the average revenue earned per item. In the second case, the average revenue would be ($1000 + $350)/(100 + 50) = $9.
In this case, the marginal revenue is less than the average revenue. However, this depends on the pricing scheme chosen. For example, a price skimming system would have a lower marginal revenue, whereas a penetration pricing system would have a higher marginal revenue than average revenue.
Calculating marginal revenue
Let’s formalize the examples above with an equation. Marginal revenue measures the change in revenue earned with a change in quantity sold. This can be expressed as follows:
Marginal Revenue = Change in Total Revenue/Change in Total Quantity
If you are comfortable with calculus, you can consider marginal revenue the first derivative of the total revenue function with respect to the quantity, but for all practical purposes you can leave the calculus at home and use simple arithmetic.
Balancing the scales of marginal revenue
In a competitive market, the price is set where the supply and demand curves meet. When the supply is increased, the new intersection with the demand curve is lower, which means the price decreases.
For example, based on your market research and understanding your customers’ willingness to pay, you are confident that you can sell 20 new subscriptions per month at $20 each, but you could sell 30 at $15 each. In this case, the marginal revenue of the 30th item would be $15, which is lower than the 20th item at $20.
For this reason, unless the demand also changes, the marginal revenue tends to decrease with the increase in quantity.
In a competitive market, equilibrium occurs when all firms produce until their marginal revenue equals their marginal cost:
(Note that MC is marginal cost, ATC is average total costs, D is demand, AR is average revenue, MR is marginal revenue, P is the market price, and Q is the quantity produced.)
In this situation, the marginal profit is zero, but the total profit is not. In fact, the total profit is maximized, which is somewhat counterintuitive. Remember that these are the marginal revenue and the marginal cost. Since the marginal revenue is either flat or decreasing over time while the marginal cost is increasing in the part of the U-shaped curve where it meets the marginal revenue curve, each previous unit has produced some marginal profit (as MR > MC). Thus, producing until the last unit generates no profit or no loss maximizes the units that have been sold at profit.
In practice, there is no solid equilibrium point, but rather a dynamic equilibrium as different firms compete and customers change their buying behaviors as a result. For example, the marginal revenue could increase over time because the consumer demand has increased, which pushes the price up. Conversely, the marginal costs could decrease because of hiring a new, more efficient production manager, which would mean that more units can be produced before the marginal revenue and marginal cost curves meet.
This can be confusing to read and more confusing to understand, especially with the intricacies of the SaaS subscription revenue model, where the expenses and revenue are considered differently. Thankfully, you don’t need to do this alone.
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When marginal revenue starts to fall
If your marginal revenue is falling, especially without a drastic change to the quantity produced, then you should take the time to do some market research and figure out why. It could be that your competitors are initiating a price war by drastically undercutting your prices, or you may have sold subscriptions to all the easy targets and now need to think about a marketing scheme to bring new eyes to your website.
If the market is feeling more competitive, then you might need to figure out a way to differentiate yourself. It could be a good time to increase your R&D budget to add new features to your platform, or simply updating the UI to match the newest aesthetics might be enough to appeal to a new generation of potential customers.
If you have increased the quantity produced and that is leading to a reduced marginal revenue, consider the benefit of that increased userbase. It may be that having fewer customers paying more is a better pricing strategy.
Marginal revenue vs. marginal benefit
Depending on the source, marginal revenue and marginal benefit can be used interchangeably. However, they are not the same thing. Marginal revenue is the incremental increase in revenue from an extra unit of production. Marginal benefit is the added utility of the consumer base from purchasing one more unit of production.
There is usually decreasing utility (economist-speak for joy, benefit, or “goodness”) from consumption, which means that every item adds a little less joy than the previous one.
For example, if you head to an all-you-can-eat buffet, you pay to eat as much as you’d like. However, that third slice of chocolate cake is not going to add as much happiness as the first. You could say there is greater marginal benefit to eating the first slice of cake than eating the third slice of cake.
Marginal analysis
Marginal analysis is the investigation of the additional benefits of a unit of activity compared to its additional costs. This is a form of cost–benefit analysis.
Marginal analysis relies on the study of marginal costs, marginal revenue, and marginal profit to keep a company focused on incrementally improving its position.
While most other forms of financial analysis take a macro view of the company or the market in which it operates, marginal analysis is a microscopic inspection of how the marginal costs and marginal revenue are changing as the quantity and/or price are changed.
Summary
Marginal revenue along with marginal cost can help you understand how to price your product as well as how much to produce. However, these are just some of the many metrics needed by a modern SaaS enterprise to thrive in the competitive, global software market.
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