Relationship of Marginal Revenue to Average Revenue

The relationship between Marginal Revenue (MR) and Average Revenue (AR) depends on the type of market structure (perfect competition, monopoly, etc.) and is crucial in determining the firm’s pricing and production decisions.

In Perfect Competition:

  • In a perfectly competitive market, Average Revenue (AR) is constant and equal to the price (P) because firms are price takers. The demand curve is perfectly elastic, meaning that the firm can sell any quantity at the market price.
  • Marginal Revenue in perfect competition is also equal to the price. This is because each additional unit sold is priced at the same rate as the previous units, so the additional revenue from selling one more unit is the same as the average revenue.

Thus, in perfect competition:

AR = MR = P

In this case, the Marginal Revenue curve and the Average Revenue curve are horizontal lines at the level of the price.

In Monopoly and Imperfect Competition:

  • In a monopolistic or imperfectly competitive market (e.g., monopolies, oligopolies), Average Revenue and Marginal Revenue behave differently. The firm has the market power to set prices, which usually means the price must be reduced to sell more units.
  • In this case, Average Revenue (AR) is still the price per unit, but Marginal Revenue (MR) decreases as more units are sold. This happens because, to sell additional units, the monopolist must lower the price for all previous units as well, resulting in a diminishing marginal revenue.
  • MR lies below the AR curve because the firm must lower the price to increase the quantity sold, and as a result, the marginal revenue from each additional unit sold is less than the average revenue.

The relationship in monopoly or imperfect competition can be summarized as:

MR < AR

Moreover, the Marginal Revenue curve typically lies below the Average Revenue curve and has a steeper slope. As the quantity of output increases, the firm’s marginal revenue decreases more rapidly than average revenue.

Key Differences in the Relationship:

  1. In Perfect Competition:
    • AR and MR are equal and constant.
    • Both curves are horizontal and coincide with the price level.
    • AR = MR = Price (P).
  2. In Monopoly and Imperfect Competition:

    • MR is always less than AR.
    • The MR curve slopes downward and is below the AR curve.
    • The AR curve is typically downward sloping, reflecting the price reduction needed to sell more units.

Implications of the Relationship

  • Pricing and Output Decisions:

In a competitive market, the firm can sell any quantity at the market price, and therefore, its marginal revenue does not decrease with increased output. However, in monopoly and imperfect competition, to sell more, the firm must lower its price, leading to a decreasing marginal revenue.

  • Profit Maximization:

The firm maximizes profit where Marginal Revenue (MR) equals Marginal Cost (MC). In perfect competition, this happens at the price level where AR = MR. In monopoly, this happens where MR = MC, but the price charged will be higher than the marginal cost, leading to higher profits.

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