Marginal Revenue

Definition

Marginal revenue refers to the additional income generated from selling one more unit of a good or service. It is a crucial concept in economics as it helps firms determine the optimal level of production and pricing strategies. The relationship between marginal revenue and price elasticity of demand is also important, as it affects how changes in output will impact overall revenue.

5 Must Know Facts For Your Next Test

1. Marginal revenue can be calculated by taking the derivative of the total revenue function with respect to quantity, showing how total revenue changes as output changes.
2. In a perfectly competitive market, marginal revenue equals the market price because firms can sell as much as they want at that price.
3. For monopolies or firms with market power, marginal revenue decreases as more units are sold, due to the necessity of lowering prices to sell additional units.
4. Understanding marginal revenue helps businesses decide whether to increase or decrease production based on whether it exceeds marginal cost.
5. When marginal revenue is equal to zero, the firm has maximized its total revenue; producing beyond this point may lead to decreased overall revenue.

Review Questions

• How does marginal revenue help firms determine their production levels?
  • Marginal revenue assists firms in deciding their production levels by comparing it with marginal cost. When a firm's marginal revenue exceeds its marginal cost, it indicates that producing an additional unit will add more to profit than it costs to make that unit. Conversely, if marginal cost exceeds marginal revenue, producing further would decrease profit. Thus, firms aim to produce until marginal revenue equals marginal cost to optimize their profit.
• Explain the difference in marginal revenue behavior between perfectly competitive firms and monopolies.
  • In perfectly competitive markets, firms are price takers and face a horizontal demand curve, leading to marginal revenue being equal to the market price. This means each additional unit sold increases total revenue by exactly the price of that unit. In contrast, monopolies face a downward-sloping demand curve, causing marginal revenue to decrease as they increase sales. A monopoly must lower its price to sell more units, resulting in marginal revenue being less than the price of the last unit sold.
• Evaluate how understanding marginal revenue can influence pricing strategies for firms with market power.
  • Understanding marginal revenue allows firms with market power to adjust their pricing strategies effectively. By analyzing how changes in output affect their marginal revenue, these firms can determine the optimal price point that maximizes total revenue. If they recognize that demand is elastic, they might lower prices to increase sales volume and thus total revenue. Conversely, if demand is inelastic, they may raise prices while still capturing consumer surplus. This strategic understanding empowers these firms to navigate their market more successfully.

Related terms

Total Revenue: Total revenue is the total income a firm receives from selling its goods or services, calculated as the price per unit multiplied by the quantity sold.

Marginal Cost: Marginal cost is the additional cost incurred by producing one more unit of a good or service, helping firms assess profitability.

Price Elasticity of Demand: Price elasticity of demand measures how the quantity demanded of a good changes in response to a change in its price, influencing marginal revenue calculations.