Marginal Revenue Product (MRP)

What Is Marginal Revenue Product (MRP)?

Marginal revenue product (MRP), also known as the marginal value product, is the marginal revenue created due to an addition of one unit of resource. The marginal revenue product is calculated by multiplying the marginal physical product (MPP) of the resource by the marginal revenue (MR) generated. The MRP assumes that the expenditures on other factors remain unchanged and helps determine the optimal level of a resource.

Understanding Marginal Revenue Product (MRP)

American economist John Bates Clark (1847-1938) and Swedish economist Knut Wicksell (1851-1926) first showed that revenue depends on the marginal productivity of additional factors of production.

Business owners frequently use MRP analysis to make critical production decisions. For example, a farmer wants to know whether to purchase another specialized tractor to seed and harvest wheat. If the extra tractor can eventually produce 3,000 additional bushels of wheat (the MPP), and each additional bushel sells at the market for $5 (the price of the product or marginal revenue), the MRP of the tractor is $15,000.

Holding other considerations constant, the farmer is only willing to pay less than or equal to $15,000 for the tractor. Otherwise, he will take a loss. Estimating costs and revenues is difficult, but businesses that can estimate MRP accurately tend to survive and profit more than their competitors.

Special Considerations

MRP is predicated on marginal analysis, or how individuals make decisions on the margin. If a consumer purchases a bottle of water for $1.50, that does not mean the consumer values all bottles of water at $1.50. Instead, it means the consumer subjectively values one additional bottle of water more than $1.50 at the time of the sale only. The marginal analysis looks at costs and benefits incrementally, not as an objective whole.

Marginalism (or marginality) is a very important concept in economics. Several critical economic insights grew out of marginalism, including marginal productivity, marginal costs, marginal utility, and the law of diminishing marginal returns.

MRP is crucial for understanding wage rates in the market. It only makes sense to employ an additional worker at $15 per hour if the worker's MRP is greater than $15 per hour. If the additional worker cannot generate an extra $15 per hour in revenue, the company loses money.

Strictly speaking, workers are not paid in accordance with their MRP, even in equilibrium. Rather, the tendency is for wages to equal discounted marginal revenue product (DMRP), much like the discounted cash flow (DCF) valuation for stocks. This is due to the different time preferences between employers and workers; employers must wait until the product is sold before recouping revenue, but workers are generally paid much sooner. A discount is applied to the wage, and the employer receives a premium for waiting.

The DMRP directly affects bargaining power between workers and employers, except the rare theoretical case of monopsony. Whenever a proposed wage is below DMRP, a worker may gain bargaining power by shopping his labor to different employers. If the wage exceeds DMRP, the employer may reduce wages or replace an employee. This is the process by which the supply and demand for labor inch closer to equilibrium.