Marginal Revenue (MR) is a key concept in economics and business, describing the additional revenue generated from selling one more unit of a good or service. It helps firms make crucial decisions about production, pricing, and overall profitability. Marginal revenue is derived from the total revenue (TR) and is calculated by finding the change in total revenue when one additional unit is sold.
Mathematically, it is represented as:
MR = ΔTR / ΔQ
Where:
- MR = Marginal Revenue
- ΔTR = Change in Total Revenue
- ΔQ = Change in Quantity Sold (usually by one unit)
Formula for Marginal Revenue
If a firm sells an additional unit of a product, the total revenue increases. The marginal revenue measures how much that total revenue increases. If we already know the total revenue for two different quantities of output, we can use the following formula:
MR = TRn − TRn−1
Where:
- TRₙ = Total revenue after selling the nth unit
- TRₙ₋₁ = Total revenue after selling the previous unit
Example of Marginal Revenue Calculation
Let’s say a company sells 100 units of a product at $50 each, which generates a total revenue of $5,000. If the firm sells an additional unit (i.e., 101 units in total) at the same price, the total revenue becomes $5,050.
The marginal revenue for the 101st unit is calculated as:
MR = TR at 101 units − TR at 100 units
MR = 5,050 − 5,000 = 50
So, the marginal revenue for selling one more unit is $50.
Relationship Between Marginal Revenue and Market Structures:
The behavior of marginal revenue varies across different market structures such as perfect competition, monopoly, monopolistic competition, and oligopoly. The relationship between MR and price depends on the market’s characteristics.
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Perfect Competition
In a perfectly competitive market, firms are price takers, meaning they cannot influence the price of the product. The price remains constant regardless of the quantity sold. This means that every additional unit sold brings the same amount of revenue, resulting in a constant marginal revenue equal to the price of the product.
For example, if a firm can sell as many units as it wants at $20 per unit, then every additional unit sold adds exactly $20 to the total revenue. Therefore, the marginal revenue curve is horizontal and equal to the price.
MR = Price (P) = AR
Graphically, the MR curve in perfect competition is a straight, horizontal line, identical to the price line.
- Monopoly
In a monopoly, a single firm dominates the market, and it has some control over the price. To sell more units, the monopolist typically has to lower the price. Consequently, the marginal revenue in a monopoly is always less than the price of the product. This is because, for each additional unit sold, the firm earns additional revenue but sacrifices some revenue by lowering the price on previous units.
For example, if a monopolist sells 10 units at $100 each, total revenue is $1,000. If it reduces the price to $90 to sell 11 units, the total revenue becomes $990. The marginal revenue for the 11th unit is calculated as:
MR = TR at 11 units − TR at 10 units
MR = 990 − 1,000 =−10
Thus, marginal revenue is less than the price, and in some cases, it can even become negative, indicating that selling an additional unit reduces the total revenue. The MR curve in a monopoly is downward sloping, always below the demand (AR) curve.
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Monopolistic Competition
Monopolistic competition is a market structure where many firms sell differentiated products. Like monopolists, firms in monopolistic competition have some control over pricing, but since their products have substitutes, they face more elastic demand curves.
The marginal revenue curve in monopolistic competition is also downward sloping and lies below the average revenue (AR) curve, similar to a monopoly. However, because of the competition, the price elasticity of demand is higher, so the firm has less pricing power than in a monopoly.
- Oligopoly
In an oligopoly, a few large firms dominate the market. Each firm’s pricing and output decisions are influenced by the actions of other firms. The behavior of marginal revenue in an oligopoly can be complex because of strategic interactions between firms. The marginal revenue curve can sometimes be kinked, reflecting sudden shifts in demand based on competitors’ pricing decisions.
For example, if one firm lowers its price, competitors might follow, causing a significant reduction in marginal revenue. On the other hand, if the firm raises its price, competitors may not follow, resulting in a less elastic demand curve for higher prices.
Importance of Marginal Revenue:
Marginal revenue plays a crucial role in various business and economic decisions:
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Profit Maximization:
Firms aim to maximize profits, which occurs when marginal revenue equals marginal cost (MR = MC). If MR exceeds MC, the firm should increase production because each additional unit adds more to revenue than to cost. Conversely, if MR is less than MC, the firm should reduce production to avoid incurring losses.
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Pricing Strategies:
Understanding marginal revenue helps firms set optimal prices. In markets where firms have some control over pricing (e.g., monopoly or monopolistic competition), the relationship between price, output, and MR informs the best pricing strategy to maximize revenue.
- Production Decisions:
Marginal revenue helps firms determine how much of a product to produce. Firms continue to produce additional units as long as MR is greater than or equal to MC. Once MR falls below MC, it becomes unprofitable to produce more units.
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Elasticity of Demand:
Marginal revenue is closely linked to the elasticity of demand. When demand is elastic, a decrease in price leads to an increase in total revenue, and MR is positive. When demand is inelastic, lowering prices reduces total revenue, and MR becomes negative. Understanding this relationship helps firms decide when to raise or lower prices.
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Revenue and Cost Analysis:
By analyzing marginal revenue alongside marginal cost, firms can make informed decisions about expanding or contracting production. This analysis is essential for efficient resource allocation and profit maximization.
Example of Marginal Revenue with a Table:
Let’s consider a hypothetical company that sells different quantities of a product at varying prices, and its total revenue changes accordingly:
Quantity Sold (Q) | Price per Unit ($) | Total Revenue (TR) | Marginal Revenue (MR) |
1 | 100 | 100 | – |
2 | 95 | 190 | 90 |
3 | 90 | 270 | 80 |
4 | 85 | 340 | 70 |
5 | 80 | 400 | 60 |
In this Table:
- When the firm sells 1 unit, TR is $100.
- When the firm sells 2 units at $95 each, TR increases to $190, and the MR is $90.
- As the firm sells more units, MR decreases because the firm must lower prices to sell additional units. The MR continues to fall, reflecting the decreasing additional revenue from selling each extra unit.
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