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What Is the Relationship between Marginal Cost and Marginal Revenue?

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  • Written By: Osmand Vitez
  • Edited By: Lauren Fritsky
  • Last Modified Date: 27 November 2016
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Marginal cost and marginal revenue are economic measurements used to determine the effects of producing one more unit in a production system. Companies typically look to reach a production equilibrium where these measurements are equal. At this point, the company will maximize its profit. The relationship between these two economic concepts is important, as an imbalance on either side can result in production inefficiencies. When an imbalance occurs, companies will experience an economy of scale.

Marginal cost increases when total cost changes by producing one additional unit. For example, 50 units cost $100 US Dollars (USD) to produce. A cost increase to $110 USD from producing 101 units indicates a marginal cost of $10 USD for the 101st unit. Each additional unit produced will go through this measurement in order to determine the marginal cost of additional products. Companies can compare the marginal cost and marginal revenue increase as part of a cost-benefit analysis.

The marginal revenue formula is a bit different than the marginal cost calculation. For example, a company can sell 10 units for $15 USD. Selling 11 units will reduce the selling price to $14 USD. The marginal revenue is $150 USD (10 x $15 USD), subtracted from $154 USD (11 x $14 USD). Marginal revenue for this product is, therefore, $4 USD.

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A comparison between the marginal cost and marginal revenue figures in this example is $10 USD in cost versus $4 USD in revenue. The company will lose $6 USD dollars by increasing its production by just one unit. This creates an equilibrium that is unsustainable for long-term production operations. Companies will, therefore, need to find another way for increasing marginal revenue when increasing production output. To figure out the equilibrium, companies will test multiple production increase figures to maximize profit.

Short-term and long-term marginal cost and marginal revenue calculations are different. Fixed costs are included in short-run calculations. In long-term calculations, however, fixed costs do not affect these measurements. Economists consider fixed costs sunk in the long term; this means the company cannot recover the cost regardless of profit earned from sales.

Economies of scale are another factor in this production estimate relationship. This economic theory states that companies will begin to incur economic disadvantages when increasing production. One reason for this comes from limited consumer demand. Consumers often have fixed income in economic terms. They must make decisions to maximize utility by purchasing goods that result in the greatest value of money spent. Overproducing goods results in high supply and carrying costs with no increased consumer demand.

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donasmrs
Post 3

@burcidi-- Yea, it would because of the law of diminishing returns.

Think of it this way. If you loved doughnuts, eating one doughnut would be very satisfactory. If you ate five, the satisfaction you receive from the fifth doughnut would be less than the first one. If you eat ten, the satisfaction you receive from the tenth doughnut would be even less than the fifth one.

Similarly, as output increases, the revenue from each additional output decreases, even when marginal cost stays the same. If marginal cost goes up, then revenue will likely be zero or in the negative.

burcidi
Post 2

@fBoyle-- If you put marginal revenue and marginal cost on a graph, you will understand this better. On a graph, you can see that when these two are equal, profit is maximum. After this point, marginal cost becomes too high and it's no longer profitable for the firm.

I understand this. What I would like to know is, as output increases, won't the marginal revenue decrease with each additional output even when marginal cost stays the same?

fBoyle
Post 1

I don't understand how profit is maximized when marginal cost equals marginal revenue. Can anyone explain?

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