Revenue Analysis
Introduction
The awareness of both revenue and cost concepts are important to a managerial economist.
Revenue and revenue curves like the cost and cost curves explain the position and the
functioning of a firm in the market. While costs indicate the expenses of a firm revenue indicates
the receipts of a firm. Revenue means the sale receipts of the output produced by the firm. It
depends on the market price. Elasticity of demand has an important bearing on the receipts of a
firm.
The amount of money, which the firm receives by the sale of its output in the market, is
known as its revenue. The major objective of a firm is to make maximum profit. Cost and
revenue concepts help in the maximization of its profit under various kinds of markets like
perfect, imperfect etc. The management of a firm should formulate an appropriate pricing policy
keeping the long run prospects in view, to attract maxim profit.
1. Total revenue (TR):
Total revenue refers to the total amount of money that the firm receives from the sale of
its products, i.e. .gross revenue. In other words, it is the total sales receipts earned from the sale
of its total output produced over a given period of time. In brief, it refers to the total sales
proceeds. It will vary with the firm’s output and sales. We may show total revenue as a function
of the total quantity sold at a given price as below.
TR = f(q). It implies that higher the sales, larger would be the TR and vice-versa. TR is
calculated by multiplying the quantity sold by its price. Thus, TR = PXQ. For e.g. a firm sells
5000 units of a commodity at the rate of Rs. 5 per unit, then TR would be Š
TR = P x Q = 5 x 5000 = 25,000.00.
2.Average revenue (AR)
Average revenue is the revenue per unit of the commodity sold. It can be obtained by
dividing the TR by the number of units sold.
Then, AR = TR/Q AR = 150/15= 10.
When different units of a commodity are sold at the same price, in the market, average revenue
equals price at which the commodity is sold for e.g. 2 units are sold at the rate of Rs.10 per unit,
then total revenue would be Rs. 20 (2×10).
Thus AR = TR/Q 20/2 = 10. Thus average revenue means price. Since the demand curve
shows the relationship between price and the quantity demanded, it also represents the average
revenue or price at which the various amounts of a commodity are sold, because the price offered
by the buyer is the revenue from seller’s point of view.
Therefore, average revenue curve of the firm is the same as demand curve of the consumer.
Therefore, in economics we use AR and price as synonymous except in the context of price
discrimination by the seller. Mathematically P = AR.
3. Marginal Revenue (MR)
Marginal revenue is the net increase in total revenue realized from selling one more unit of a
product.
It is the additional revenue earned by selling an additional unit of output by the seller.
MR differs from the price of the product because it takes into account the effect of changes in
price.
Mathematically it can be expressed as-
MR = ΔTR/ΔQ
where ΔTR represents change in TR
ΔQ = indicates change in total quantity sold.
For example if a firm can sell 10 units at Rs.20 each or 11 units at Rs.19 each, then the marginal
revenue from the eleventh unit is (10 × 20) – (11 × 19) = Rs.9.
If the price of a product falls when more of it is offered for sale then that would involve a loss on
the previous units which were sold at a higher price before and is now sold at the reduced price
along with the additional one. This loss in the previous units must be deducted from the revenue
earned by the additional unit.
Suppose a firm is selling 4 units of the output at the price of Rs.14 per unit. Now if it wants to
sell 5 units instead of 4 units and thereby the price of the product falls to Rs.12 per unit, then the
marginal revenue will not be equal to Rs.12 at which the 5th unit is sold. 4 units, which were sold
at the price of Rs.14 before, will all have to be sold at the reduced price of Rs.12 and that will
mean the loss of 2 rupees on each of the previous 4 units. The total loss on the previous units will
be equal to Rs.8. Therefore, this loss of 8 rupees should be deducted from the price of Rs.12 of
the 5th unit while calculating the marginal revenue. The marginal revenue in this case, therefore,
will be Rs.12 – Rs.8 =Rs.4 and not Rs.12 which is the average revenue.
Marginal revenue can also be directly calculated by finding out the difference between the total
revenue before and after selling the additional unit of the product.
MR= TRn – TRn-1
Total revenue when 4 units are sold at the price of Rs.14=4X14=Rs.56
Total revenue when 5 units are sold at the price of Rs.12=5X12=Rs.60
Therefore, Marginal revenue or the net revenue earned by the 5th unit = 60-56=Rs.4.
Thus, Marginal revenue of the nth unit = difference in total revenue in increasing the sale from n-
1 to n units or
Marginal revenue = price of nth unit minus loss in revenue on previous units resulting from price
reduction.
The concept is important in micro economics because a firm’s optimal output (most profitable) is
where its marginal revenue equals its marginal cost i.e. as long as the extra revenue from selling
one more unit is greater than the extra cost of making it, it is profitable to do so.
It is usual for marginal revenue to fall as output goes up both at the level of a firm and that of a
market, because lower prices are needed to achieve higher sales or demand respectively.
Units Price TR AR MR
1 20 20 20 -
2 18 36 18 16
3 16 48 16 12
4 14 56 14 8
5 12 60 12 4
According to the table, people will not buy more than 4 units at a price of Rs.14.00. To sell more,
price must drop. Suppose that to sell 5 units, the price must drop to Rs.12. What will the
marginal revenue of the 5th unit be?
Total revenue when 4 are sold is Rs.56. When 5 units are sold, total revenue is (5) x (Rs.12) =
Rs.60. The marginal revenue of the 5th unit is only Rs.4.
To see why the marginal revenue is less than price, one must understand the importance of the
downward-sloping demand curve.
To sell another unit, seller must lower price on all units. He received an extra Rs.4 for the 5th
unit, but lost Rs.8 on 4 units he was previously selling. So the net increase in revenue was Rs.12
minus Rs.8 or Rs.4.
There is another way to see why marginal revenue will be less than price when a demand curve
slopes downward. Price is average revenue. If the firm sells 4 units for Rs.14, the average
revenue for each unit is Rs.14.00. But as seller sells more, the average revenue (or price) drops,
and this can only happen if the marginal revenue is below price, pulling the average down.
If one knows marginal revenue, one can tell what happens to total revenue if sales change. If
selling another unit increases total revenue, the marginal revenue must be greater than zero. If
marginal revenue is less than zero, then selling another unit takes away from total revenue. If
marginal revenue is zero, than selling another does not change total revenue. This relationship
exists because marginal revenue measures the slope of the total revenue curve.
Relationship between Total revenue, Average revenue and Marginal Revenue concepts
In order to understand the relationship between TR, AR and MR, we can prepare a hypothetical
revenue schedule.
Number of Units sold TR (Rs.) AR (Rs.) MR (Rs.)
1 10 10 –
2 18 9 8
3 24 8 6
4 28 7 4
5 30 6 2
6 30 5 0
7 28 4 -2
From the table, it is clear that:
1. MR falls as more units are sold.
2. TR increases as more units are sold but at a diminishing rate.
3. TR is the highest when MR is zero
4. TR falls when MR become negative
5. AR and MR both falls, but fall in MR is greater than AR i.e., MR falls more steeply than
AR.
Relationship between AR and MR and the nature of AR and MR curves under difference
market conditions
1. Under Perfect Market
Under perfect competition, an individual firm by its own action cannot influence the market
price. The market price is determined by the interaction between demand and supply forces. A
firm can sell any amount of goods at the existing market prices. Hence, the TR of the firm
would increase proportionately with the output offered for sale. When the total revenue increases
in direct proportion to the sale of output, the AR would remain constant. Since the market price
of it is constant without any variation due to changes in the units sold by the individual firm, the
extra output would fetch proportionate increase in the revenue. Hence, MR & AR will be equal
to each other and remain constant. This will be equal to price.
Price per Unit Rs. 8.00
Number of Units sold
AR TR MR
1 8 8 8
2 8 16 8
3 8 24 8
4 8 32 8
5 8 40 8
6 8 48 8
Under perfect market condition, the AR curve will be a horizontal straight line and parallel to
OX axis. This is because a firm has to sell its product at the constant existing market price. The
MR cure also coincides with the AR curve. This is because additional units are sold at the same
constant price in the market.
2. Under Imperfect Market
Under all forms of imperfect markets, the relation between TR, AR, and MR is different. This
can be understood with the help of the following imaginary revenue schedule.
Number of Units sold TR AR or price in Rs. MR
1 10 10 10
2 18 9 8
3 24 8 6
4 28 7 4
5 30 6 2
6 30 5 0
7 28 4 -2
From the above table it is clear that: In order to increase the sales, a firm is reducing its price,
hence AR falls.
1. As a result of fall in price, TR increase but at a diminishing rate.
2. TR will be higher when MR is zero
3. TR falls when MR becomes negative
4. AR and MR both declines. But fall in MR will be greater than the fall in AR.
5. The relationship between AR and MR curves is determined by the elasticity of demand
on the average revenue curve.
Under imperfect market, the AR curve of an individual firm slope downwards from left to
right. This is because; a firm can sell larger quantities only when it reduces the price. Hence, AR
curve has a negative slope.
The MR curve is similar to that of the AR curve. But MR is less than AR. AR and MR curves are
different. Generally MR curve lies below the AR curve.
The AR curve of the firm or the seller and the demand curve of the buyer is the same
Since, the demand curve represents graphically the quantities demanded by the buyers at various
prices it shows the AR at which the various amounts of the goods that are sold by the seller. This
is because the price paid by the buyer is the revenue for the seller (One man’s expenditure is
another man’s income). Hence, the AR curve of the firm is the same thing as that of the demand
curve of the consumers.
Suppose, a consumer buys 10 units of a product when the price per unit is Rs.5 per unit. Hence,
the total expenditure is 10 x 5 = Rs.50/-. The seller is selling 10 units at the rate of Rs.5 per unit.
Hence, his total income is 10 x 5 = Rs.50/-. Thus, it is clear that AR curve and demand curve is
really one and the same.
Relationship Between Revenue Concepts And Price Elasticity Of Demand
Relationship between AR, MR, TR and Elasticity of Demand
In the diagram AR is the average revenue curve, MR is the marginal revenue curve and OD is
the total revenue curve. At the middle point C of average revenue curve elasticity is equal to one.
On its lower half it is less than one and on the upper half it is greater than one. MR
corresponding to the middle point C of the AR curve is zero. This is shown by the fact that MR
curve cuts the x axis at Q which corresponds to the point C on the AR curve. If the quantity is
greater than OQ it will correspond to that portion of the AR curve where e<1 marginal revenue is
negative because MR goes below the x axis. Likewise for a quantity less than OQ, e>1 and the
marginal revenue is positive. This means that if quantity greater than OQ is sold, the total
revenue will be diminishing and for a quantity less than OQ the total revenue TR will be
increasing. Thus the total revenue TR will be maximum at the point H where elasticity is equal to
one and marginal revenue is zero.
Mathematically the relationship between AR,MR, elasticity can be expressed-
e = AR/AR-MR
