In a perfectly competitive market, the additional revenue generated by selling an additional unit of a good is equal to the price the firm is able to charge the buyer of the good. This is because a firm in a competitive market will always get the same price for every unit it sells regardless of the number of units the firm sells since the firm's sales can never impact the industry's price.
However, a monopoly determines the entire industry's sales. As a result, it will have to lower the price of all units sold to increase sales by 1 unit. Therefore, the marginal revenue generated is always lower than the price the firm is able to charge for the unit sold, since each reduction in price causes unit revenue to decline on every good the firm sells. The marginal revenue (the increase in total revenue) is the price the firm gets on the additional unit sold, less the revenue lost by reducing the price on all other units that were sold prior to the decrease in price.
A firm’s profits will be maximized when marginal revenue (MR) equals marginal cost (MC). If then a profit-maximizing firm will increase output for more profit, while if then the firm will decrease output for additional profit. Thus the firm will choose the profit-maximizing output level as that for which .
Marginal revenue is equal to the ratio of the change in revenue for some change in quantity sold to that change in quantity sold. This can also be represented as a derivative when the change in quantity sold becomes arbitrarily small. Define the revenue function to be
where the prime sign indicates a derivative. For a firm facing perfect competition, price does not change with quantity sold (), so marginal revenue is equal to price. For a monopoly, the price decreases with quantity sold (), so marginal revenue is less than price (for positive )
Marginal revenue curve
The marginal revenue curve is affected by the same factors as the demand curve – changes in income, changes in the prices of complements and substitutes, changes in populations, etc. These factors can cause the MR curve to shift and rotate.
Relationship between marginal revenue and elasticity
where R is total revenue, P(Q) is the inverse of the demand function, and e < 0 is the price elasticity of demand. If demand is inelastic (e > –1) then MR will be negative, because to sell a marginal (infinitesimal) unit the firm would have to lower the selling price so much that it would lose more revenue on the pre-existing units than it would gain on the incremental unit. If demand is elastic (e < –1) MR will be positive, because the additional unit would not drive down the price by so much. If the firm is a perfect competitor, so that it is so small in the market that its quantity produced and sold has no effect on the price, then the price elasticity of demand is negative infinity, and marginal revenue simply equals the (market-determined) price.
Marginal revenue and markup pricing
Profit maximization requires that a firm produces where marginal revenue equals marginal costs. Firm managers are unlikely to have complete information concerning their marginal revenue function or their marginal costs. However, the profit maximization conditions can be expressed in a “more easily applicable form”:
- MR = MC,
- MR = P(1 + 1/e),
- MC = P(1 + 1/e),
- MC = P + P/e,
- (P - MC)/ P = –1/e.
Markup is the difference between price and marginal cost. The formula states that markup as a percentage of price equals the negative (and hence the absolute value) of the inverse of the elasticity of demand.
(P - MC)/ P = –1/e is called the Lerner index after economist Abba Lerner. The Lerner index is a measure of market power — the ability of a firm to charge a price that exceeds marginal cost. The index varies from zero (when demand is infinitely elastic (a perfectly competitive market) to 1 (when demand has an elasticity of –1). The closer the index value is to 1, the greater is the difference between price and marginal cost. The Lerner index increases as demand becomes less elastic.
Alternatively, the relationship can be expressed as:
- P = MC/(1 + 1/e).
Thus, for example, if e is –2 and MC is $5.00 then price is $10.00.
Example If a company can sell 10 units at $20 each or 11 units at $19 each, then the marginal revenue from the eleventh unit is (11 × 19) - (10 × 20) = $9.
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