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Revenue:Total, Marginal and Average

Revenue:Total, Marginal and Average

Author: Kate Eskra

This lesson will explain Revenue:Total, Marginal and Average

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Hi. Welcome to Economics. This is Kate.

This tutorial is on revenues-- total revenue, marginal revenue, and average revenue. As always, my key terms are in red and my examples are in green. So in this tutorial, we'll be talking about all of the different revenues-- total, marginal, and average. You'll understand something called the "price effect" and the output "output effect" and how they're different in different types of industries, whether they're competitive or imperfectly competitive.

So we know that the point of owning a business is to make a profit, and we also are aware that profit equal our revenues minus our costs. I just wanted to remind you for this tutorial, we're focusing on this side-- the revenue side of things.

OK. So let's start with total revenue. "Total revenue" is simply the amount received from sales of the good or service produced. Very often, you'll hear people interchange the word "revenue" and "sales" because that's what it is.

So total revenue is simply the price that you're charging for your product times however many you're selling. And in perfect competition, remember, they have no control over price. They're a pricetaker. There's only one the price that they can charge for their good.

So in perfect competition, notice, if we sell 0 t-shirts, our total revenue is nothing. Price times quantity. If we sell 1 t-shirt, now our total revenue is 15. If we sell 2, it's 30, and so on and so forth. Notice that it's just going to go up by 15 each time because there's only one price that can be charged. So total revenue's pretty simple-- just price times quantity.

Now, let's talk about marginal revenue. "Marginal revenue" is the additional revenue resulting from the increase of product sales by one unit. Remember, that word "marginal" means additional every time, so you're looking at things incrementally when we're increasing by one unit. So again, let's take a look at perfect competition first. Marginal revenue always will be the change in total revenue divided by the change in quantity.

So in our perfect competition example, here we had total revenue. Marginal revenue is simply the change from one unit to the next. So it goes up by 15 each time. So notice, marginal revenue is actually really easy if you're looking at a perfect competitor since, every time you sell one more, you simply take in an additional price of the product here, $15. So marginal revenue and price are the same thing for a perfect competitor.

But in imperfect markets, to sell more, the firm has to lower price. They do have control over price. So for an imperfect competitor, they try to figure out, "How much do we want to sell?"

If they're selling nothing, they know it's because their price is too high. So they can lower price and sell one more. If they want to sell more, they lower price again. So that means that total revenue will not be increasing by the same amount every single time. So that means marginal revenue will not be equal to the price either.

So here, our total revenue is 10 when we sell 1. It's 18 when we sell 2 because 2 times 9 is 18. So our marginal revenue then goes up by 8.

Here, it goes up by 6. From 18 up to 24, it goes up by 4, goes up by 2, 0. It can actually be negative. OK. So obviously, I think you can probably see into the future here and realize that we would never want to do this because that would mean that we're taking in negative dollars-- or we're losing money from that one.

Now, we need to talk about the output in price effect. So the additional revenue that they are going to gain from selling more is known as the "output effect." So it's defined as the revenue received from selling additional units of a good or service.

OK. So back to this example here, notice, when they lowered price from 10 down to 9, the advantage of that was that they got to sell one more unit. The output effect is that $9 that they gained from picking up customer 2 here.

All right. So they gained $9 from dropping the price down to 9. That is the "output effect."

But let's think about what happened here. What happened is, in order to sell more, we know they lowered price down to 9, but they also have to drop the price down to 9 for this person up here-- for person number 1. So even the customers who were willing to pay more now are paying the lower price. We're losing out on that ability to charge them the higher price when we lower it. So this foregone revenue from the original customers is known as the "price effect."

OK. So in this example here, they lost out on the ability to charge the first customer $10. Like I said, the "price effect" itself would be that $1 that they lost out on charging the first customer. So instead of 10, they were only able to charge that first customer 9. So that's why their marginal revenue is going to fall. Marginal revenue will not be equal to the price, as it was in perfect competition, and the change in total revenue or marginal revenue will be the output effect minus the price effect.

So here, it was the $9 output effect because, yes, we gained $9 from selling to customer number 2, but we lost $1 from not being able to charge this person the higher price of $10. Instead, we're charging them 9. So the difference between those two effects is our marginal revenue of $8, and you can see here that's what it is.

OK. So the price effect then was defined as, in order to sell additional units, competitive firms must lower their price. The price effect represents the loss in revenue resulting from this price drop.

So just one note here. Notice that total revenue-- your total amount of sales-- will actually be the highest where marginal revenue is 0. So why is that? Most of the time, people think, well, why would you ever want your marginal revenue to be 0? Well, again, it has to do with the word here, "marginal." So you're going to max out your total revenue when that hits 0 because, if the firm gains even one additional dollar-- marginal revenue-- from selling the next unit, that's going to add to their total revenue.

Now, I want you to be careful here. That doesn't mean that this is where they're necessarily going to produce because we haven't even looked at the cost side of things. So that may not-- and probably won't-- be where they maximize their profits, but it's just something worth mentioning-- that they will be maximizing their total revenue when marginal hits 0.

So again, looking at it this way, if change in total revenue is the output effect minus the price effect, if this-- the output effect-- is greater than the price effect, then total revenue will increase. And vice versa. If the output effect is less, then the price effect-- total revenue-- would decrease.

All right. In perfect competition, again, it's pretty easy because perfectly competitive firms can only charge one price. There's no price effect. There's no lowering the price and losing out on other customers.

They can sell all they want, in theory, at that price. So there's no incentive for them to lower it, and they certainly can't raise price. So that means that marginal revenue will always, always, always equal price if we're dealing with a perfectly competitive industry.

All right. And then there's one last revenue we have to consider, and that's average revenue, which is total revenue divided by the quantity sold. So if you notice here, average revenue-- if we just take total revenue divided by the quantity, it turns out, if we're charging all customers the same price, then it's just going to be the same as price. So average revenue is usually a pretty easy one because, again, if we're charging everyone that same price, average revenue will be equal to the price.

So in this tutorial, we looked at all the different ways that we can look at revenue-- in total, marginally-- or incrementally-- and then as an average. And we talked about the price and output effects, and I showed you how it's different in perfect competition and an imperfectly competitive firms. Thank you so much for listening. Have a great day.

Notes on "Revenue: Total, Marginal and Average"

Terms to Know

Total Revenue

The amount received from sales of the good or service produced.

Marginal Revenue

The additional revenue resulting from the increase of product sales by one unit.

Output Effect

The revenue received from selling additional units of a good/service.

Price Effect

In order to sell additional units, competitive firms must lower their price.  The price effect represents the loss in revenue resulting from this price drop.

Average Revenue

Total revenue divided by the quantity sold.