The concept of marginal revenue is closely related to the price elasticity of demand. The word ‘margin’ always refers to something extra. Therefore, marginal revenue is achieved by selling an additional unit of a good (or service).
What is marginal revenue?
Meaning of Marginal revenue: – Marginal revenue is the incremental revenue for each unit sold. Analyzing marginal revenue helps a company identify the revenue generated from one additional unit of production. A company that sells high-volume products benefits from economies of scale, which allow them to lower prices, thereby increasing sales volume.
To keep the demand high, the price is further reduced. The more a company sells, the more it can save, and more of those savings can be transferred to the customer. When marginal revenue falls below marginal cost, firms typically do a cost-benefit analysis and halt production. The natural monopoly is operated by a low-cost leader.
The formula for marginal revenue can be expressed as: –
Marginal Revenue (MR)= Change in Revenue / Change in Quantity= ΔTR / ΔQ
What is price elasticity of demand?
Meaning of Price Elasticity of Demand: – The price elasticity of demand is a measure of how a product’s usage changes in response to price changes. Price elasticity of demand measures the responsiveness of the quantity demanded or supplied of a good to a change in its price. It is computed as the percentage change in quantity demanded-or supplied-divided by the percentage change in price.
In the world of microeconomics, goods are either elastic or inelastic. The demand for an elastic commodity is greatly influenced by the price. For example, there are many different brands of almond butter. There are also several different substitutes for the product, including peanut butter and cashew butter. For this reason, an increase in price will lead to a decrease in demand as customers opt for a lower priced product. The more demand changes with price, the more elastic a commodity is.
What is Inelasticity of Demand?
Meaning of Inelasticity of Demand: – Inelastic demand means that there is only a slight (or no change) in quantity demanded of the good or service when another economic factor is changed. If demand for a good or service remains unchanged even when the price changes, demand is said to be inelastic. Inelastic goods consist of items such as tobacco and prescription drugs. Inelastic products are necessities and, usually, do not have substitutes they can easily be replaced with.
The income elasticity of demand is also known as the income effect. The income level of a given population can influence the demand elasticity of goods and services. For example, suppose that an economic event leads to many workers being laid off. During this time period, people may decide to save their money rather than upgrading their smartphones or buying designer purses. This would lead to luxury items becoming more elastic. In other words, a slight change in income level would lead to a significant change in the consumption of luxury goods.
An inelastic good is one where a change in price does not cause a change in demand. If you raise the price of a life-changing drug, it won’t change demand, and substitutes for life-changing drugs rarely exist. Only legal monopolies exist for price-inelastic goods, because price is not a driver of demand. A legal monopoly is created by the exclusive right to use a patent, copyright or intangible asset.
Relation between Price elasticity and Marginal revenue
There is a direct relationship between price elasticity and marginal revenue. The more elastic a commodity is, the more its demand is affected by changes in supply. In a competitive market, marginal revenue is proportional to price. Therefore, in a competitive market, price elasticity is directly related to marginal revenue. In a natural monopoly, marginal revenue is less than the price. This is because low prices are the primary driver of monopolies. Therefore, in a monopoly, price elasticity is directly related to marginal revenue.
Marginal Revenue and Price Elasticity
Marginal revenue is driven by price and cost, both of which are a function of demand. Higher prices and lower costs generate higher revenue. Higher volumes generate higher revenue and lower costs through economies of scale. The effect is cyclical, and the benefit of cost savings is countered by the loss of revenue from lower prices. If the price of the commodity is inelastic, the change in price will not affect the demand.
Marginal revenue is the rate of change in total revenue as production (sales) changes by one unit. In perfect competition, marginal revenue is always equal to average revenue, or price, because the firm can sell as much as it wants at market price.
So, the firm is a price taker. This is because the demand for the firm’s product is perfectly elastic. The following is a perfectly elastic demand curve. It is often used to denote the price and output behavior of a firm under pure competition. Here, dP/dQ = 0.
But in monopoly or imperfect competition, a firm is a price maker. Therefore, it will have to lower the price to sell more. The above image shows that the demand for the firm’s product is not perfectly elastic.
As a result, both marginal revenue (MR) and average revenue (AR) fall (when the price goes down). But MR falls faster than AR and the MR curve is below the AR curve. In the above image, the explanation of the difference between price and marginal revenue is quite simple: by adding the last unit to sales quantity Q, the firm accepts a reduction in price for all ex-marginal (Q-1) units.
For all markets other than purely competitive markets, the MR function is less than the demand (or average revenue) function for all units produced earlier than expected. In other words, MR is less than the price. MR can be expressed as MR = dTR/dQ, where dTR with respect to dQ is the first derivative of the total revenue function.
MR can alternatively be expressed as: –
MR = P[1-(1/ Ep)]
MR = Marginal Revenue,
P = Market Value of the product, and
Ep = price elasticity of demand for the product
The above formula is very useful when the demand function has a known constant price elasticity. Business managers must estimate the value of MR in order to make decisions about price and output.