Revenue

BIBLIOGRAPHY

A firm’s revenue is distinguished from its profit: Revenue is the total money received by the firm (“total revenue”), whereas profit is total revenue less total cost. Revenue and total revenue are usually synonyms, but the latter term is used especially to delineate total money received, as distinct from the “marginal revenue” of each unit and the “average revenue” received for all units.

Marginal revenue is a central concept in microeconomic theory (Marshall [1890] 1961). It is the change in total revenue created by a one-unit increase in the quantity sold. As long as marginal revenue is positive, increasing output will cause total revenues to increase. Mathematically, marginal revenue is the derivative of total revenue with respect to quantity. Average revenue is the money collected per unit, or total revenue divided by quantity. When all units of a firm’s output (q ) are sold for the same price (p ), total revenue is price multiplied by quantity, pq, and both marginal and average revenue are equal to price.

A perfectly competitive firm’s marginal revenue is determined solely by price because a single firm’s chosen quantity of production has a negligible effect on the market price. When one firm in a perfectly competitive market decides to produce and sell one more unit of output, the market price does not change, and so the increase in the firm’s revenues is exactly equal to the number of dollars brought in by that extra unit: its price. The mathematics behind this intuition recognizes that in this case, the derivative of total revenue is d (pq )/dq = p because price (p ) does not change as the firm’s output (q ) changes.

A firm with market power wields a double-edged sword. The firm can set the price for its output, but it still must contend with a downward-sloping demand curve: Selling more output requires a decrease in price, by the “law of demand.” Because of these two effects (increasing quantity while decreasing price), marginal revenue is made up of two components. When the firm decides to produce and sell one more unit of output, (1) selling more of the good increases revenue, while (2) lowering price means that less revenue is collected on each of the units that could have been sold at the higher price. Thus marginal revenue must be less than price for a firm with market power (rather than equal to price, as in the case of perfect competition, above). The two components of revenue are, respectively, the output effect and the price effect. A mathematical analysis recognizes that price now changes as the firm’s quantity changes: The derivative dp /dq is nonzero. The derivative of total revenue is thus d (pq )/dq = p + (dp /dq )q. The first term is the output effect and the second term is the price effect. The price effect is negative because price falls when quantity rises, and this means that the marginal revenue of producing and selling one more unit of output is less than the price for which each unit can now be sold.

Marginal revenue is also closely related to the own-price elasticity of demand, or the responsiveness of quantity demanded to a change in price. A decrease in price when demand is “elastic” causes a greater percentage increase in quantity demanded than the percentage decrease in price—thus revenues must increase. A decrease in price when demand is “inelastic,” in contrast, causes a smaller reaction in quantity demanded, and so revenues will fall. This is especially relevant when a firm is choosing the optimal quantity to sell and costs are fixed as the quantity sold changes: Maximizing total revenue is equivalent to maximizing profits in this case. For example, a toll-road operator should decrease price as long as the resulting increase in drivers (quantity) compensates for the loss in revenue per unit. In other words, price should be decreased as long as demand is still elastic. Total revenue (and in this case, profits) will be maximized when demand is neither elastic nor inelastic. This is also the quantity at which marginal revenue is zero.

The firm with market power thus far has been assumed to sell all units of its output for the same price; that is, it does not “price discriminate.” When the firm does price discriminate it can do so either by setting separate prices for each customer or setting separate prices for different customer groups, or by adjusting price according to each customer’s quantity purchased. Average revenue will vary as quantity changes, depending on the method of price discrimination, and so total revenue may not be simply price multiplied by total quantity. One example is a quantity discount: In this case, larger quantities will have lower average revenue than smaller quantities. Another example is when the customer must pay a fee for the right to purchase each unit (a “cover charge” or “membership fee”): Total revenue includes both this fee and the revenues collected on each unit’s sale, so average revenue (per unit sold) decreases as quantity increases.

In fact, the ability to price discriminate allows the firm with market power to reduce the negative effect that the law of demand has on marginal revenue. The firm can set a higher price for those units of output for which customers have a higher willingness to pay, and set a lower price only for those units of output for which there is a lower willingness to pay. As output increases, charging separate prices for each unit or group of units purchased mitigates the price effect. The price effect may even fall to zero. Thus, when the firm price discriminates, it can be true that marginal revenue approaches price and the economic outcome may approach that of perfect competition, except that the economic value created is reallocated toward the price discriminating firm and away from the customer. This means that a firm with market power may produce more output if it can price discriminate than if it cannot. The firm will benefit from this practice, and this advantage to society may more than outweigh the loss to the consumer.

SEE ALSO Revenue, Average; Revenue, Marginal

BIBLIOGRAPHY

Marshall, Alfred. [1890] 1961. Principles of Economics. 8th ed. New York: Macmillan.

Christopher S. Ruebeck

Revenue

What It Means

Revenue is the total quantity of money that a business brings in during a set period of time. Most revenue results from the sale of goods and services. Therefore, revenue is equal to the price times the quantity (in units, weight, or some other measure) of all products sold in the time period under consideration. For example, if a street vendor sells 100 hot dogs in one day at a price of $3 apiece, her business’s revenue would be $300 for that day. If a company sells more than one product, the price-times-quantity calculation would be performed for each product, and the resulting totals would be added together.

It is important to distinguish revenue from profit (also called net income). Profit is calculated by subtracting a company’s costs from its revenues. If the hot-dog vendor pays $20 a day to rent her cart and $50 a day to stock it, her costs would equal $70 and her profit $230. Revenue is often referred to as a company’s “top line,” and profit is often referred to as a company’s “bottom line,” since these figures appear, respectively, at the top and bottom of income statements (company documents that break down how revenue is transformed into profit).

The goal of any company, from the perspective of economics, is to maximize profits. This depends on making accurate decisions concerning revenue and cost so that the gap between these two amounts—profit—reaches its widest possible range. Likewise, from the investor’s point of view, revenue is a crucial ingredient in the health of any business. Investors want to buy stock (shares of company ownership that gain value when the firm prospers) in companies that are healthy and well-positioned for future growth. To measure up to this standard, a company must show steady growth not only in profits but also in revenue.

When Did It Begin

The concept of revenue, along with the corresponding concept of profit, is of central importance in any market economy (a system in which the activity of buyers and sellers acting independently shapes most aspects of economic life). In Europe market economic systems, also called capitalist systems, began supplanting planned economies, in which a ruler or other central authority is responsible for all important economic decisions, in the sixteenth through eighteenth centuries.

In the planned economies that predated market-based capitalism, wealth was generally synonymous with land ownership. Rulers were typically chosen from among an elite group of landowners, and most economic activity was carried out for that group’s benefit. Although markets allowing people to buy and sell their goods existed under planned economic systems, the revenue generated by the sale of goods and services was subject to the commands of the ruling elite. The products bought and sold in markets were often what was left over after producers had satisfied their obligations to their rulers.

The rise of market economies gave business owners the right to keep their profits. Of course, with this right came the necessity of managing revenue and costs. Whereas a planned economy may have supported a business enterprise that operated at a loss (in other words, one whose costs exceeded its revenues), the market system provides no such support. Any business that hopes to survive in a market economy must at a minimum bring in enough revenue to pay its costs.

More Detailed Information

Revenue is calculated by multiplying the price of a product by the quantity sold. A company’s total revenue grows in different ways as quantity increases, depending on the degree of competition in its market.

In a perfectly competitive market for any product, a business has no control over price. There are numerous small sellers, none of whom is able to affect the selling price. Price is set by the competing forces of supply (the amount sellers are willing to sell at a given price) and demand (the amount buyers are willing to buy at a given price). In this situation, revenue increases at a steady rate as quantity increases.

To illustrate this point, consider an asparagus farmer in a perfectly competitive market. If the price of asparagus is set by the forces of supply and demand at $2 per pound, then it does not matter whether the farmer sells 10 pounds of asparagus or 10,000 pounds of asparagus; he will still be paid the same price per unit. His revenue increases by $2 for each pound he sells, no matter what. Since he cannot change the price, the only way for him to increase revenue is to sell more asparagus.

Revenue increases at different rates under other market conditions. In addition to perfect competition, there are three other basic market forms: monopoly, in which one firm is the only seller of a product; oligopoly, in which a few firms control the market for a product and have substantial control over prices; and monopolistic competition, in which there are numerous firms that have some amount of control over prices. In these market structures the price for which a product is sold changes with the quantity of the product sold.

For example, imagine a drug company that has a patent on (the legal right to be the only seller of) a new pill that is the only effective treatment for a particular disease. The drug company has a monopoly on its market: there is no other drug available to treat that disease, and no one else can sell the chemical formula that constitutes that drug until the patent expires. Since the company does not have to worry about competitors taking away its customers, it can set any price for the drug it wants. The more it charges for its pills, however, the lower the quantity demanded will be.

This results in changing levels of revenue. Say that at $10 per pill the company attracts no customers; this would result in total revenues of zero. At $7.50 it may be able to sell 200,000 pills, resulting in revenues of $1.5 million. If the company lowers its price to $5 per pill, it may be able to sell half a million pills, resulting in revenues of $2.5 million. At a price of $2.50, the drug company may be able to sell a million pills, but notice that the total revenue would be the same as at a price of $5: $2.5 million.

This basic pattern of revenue growth relative to price and quantity would apply to any market in which a seller has some control over prices. When a firm has control over prices, it must lower prices to increase revenue. Revenue in such a market does not increase at a constant rate, however, and it only increases up to a point, after which it will begin to decrease.

When a business makes decisions about how much to produce in order to maximize profits, revenue accounts for half of the information it needs. The other half comes in the form of cost, the sum of its expenses on materials, labor, and other resources that go into producing those goods and services. Cost varies with the quantity of goods produced, so a company must find the level of output that maximizes the difference between costs and revenues.

Recent Trends

Companies that issue stock to investors are literally owned by those shareholders, and they have legal responsibilities toward them. Therefore, public companies, as they are called, periodically report on their financial status. Today, businesses issue what are known as “earnings calls,” teleconferences with shareholders, financial analysts, and other interested parties during which the company’s recent performance is discussed. The executives who conduct the earnings calls, along with their audience, typically consider revenue to be as important an indicator of the company’s future prospects as profit.

For example, a company whose top line, that is, revenue, is growing steadily might be considered in healthy shape even if its profit or bottom-line growth is flat. This might be because one-time expenses, such as purchases of new equipment, can periodically cut into profits without damaging the company’s overall outlook for the future, assuming that revenue growth remains strong. On the other hand, a company could manage to create profit growth by cutting costs even if it generated no top-line growth. This is not as desirable, from the point of view of a shareholder or potential investor, as profit growth that is derived from revenue growth. For a company’s stock to remain enticing to investors, that company must show steady top-line as well as bottom-line growth.

REVENUE

Revenue is a term commonly used in business. A company's revenue is all of the money it takes in as a result of its operations. Another way of defining a company's revenue is as a monetary measure of outputs, or goods sold and services rendered, with expense being a monetary measure of inputs or resources used in the production of goods or services. On the other hand, a company's net income or profit is determined by subtracting its expenses from its revenues. Thus, revenues are the opposite of expenses, and income equals revenues minus expenses.

For accounting purposes, income is distinguished from revenues. Income is an important concept in economics as well as accounting. Accountants prepare an income statement to measure a company's income for a given accounting period. Economists are concerned with measuring and defining such concepts as national income, personal income, disposable personal income, and money income versus real income. In each field the concept of income is defined in slightly different terms.

An example of revenue is when a store sells $300 worth of merchandise, for which it originally paid $200. In this example the company's revenue is $300, its expense is $200, and its net income or profit is $100. Other expenses that are typically deducted from sales or revenues include salaries, rent, utilities, depreciation, and interest expense.

See also: Income

rev·e·nue / ˈrevəˌn(y)oō/ • n. income, esp. when of a company or organization and of a substantial nature. ∎  a state's annual income from which public expenses are met. ∎  (revenues) items or amounts constituting such income: the government's tax revenues. ∎  the government department collecting such income.

revenue †yield or profit of property; income from possessions XV; (annual) income gen.; department of the civil service dealing with national funds XVII. — (O)F. revenu, †revenue, m. and fem. pp. of revenir :- L. revenīre return, f. RE- + venīre COME.