MC stands for marginal extra cost incurred by a firm when its production raises by one unit. MR stands for marginal extra revenue a firm receives from producing one extra unit of output. As a firm is trying to maximise its profits, it needs to consider what happens when it changes its production by one unit.
The firm will of course incur an extra cost from producing an extra unit, but will also receive revenue from that unit. The other form can be illustrated by drawing the demand and isoprofit curves, and showing the tangency point. In empirical work it is sometimes easier to estimate a revenue function than a demand function. In Leibniz 7. But whichever method is used, the first-order conditions are equivalent, and the solution for the profit-maximizing quantity is therefore the same.
Read more: Sections 6. Mathematics for economists: An introductory textbook , 4th ed. Manchester: Manchester University Press. This ebook is developed by the CORE project. More information and additional resources for learning and teaching can be found at www.
The Economy. Leibniz 7. Thus: Revenue at any point on the demand curve can be represented graphically as the red rectangle below the curve, as shown in Figure 7. In , after years of legal appeals, the U. Supreme Court held that the broader market definition was more appropriate, and the case against DuPont was dismissed. Questions over how to define the market continue today.
The Greyhound bus company may have a near-monopoly on the market for intercity bus transportation, but it is only a small share of the market for intercity transportation if that market includes private cars, airplanes, and railroad service.
DeBeers has a monopoly in diamonds, but it is a much smaller share of the total market for precious gemstones and an even smaller share of the total market for jewelry. In general, if a firm produces a product without close substitutes, then the firm can be considered a monopoly producer in a single market. But if buyers have a range of similar—even if not identical—options available from other firms, then the firm is not a monopoly. Still, arguments over whether substitutes are close or not close can be controversial.
No monopolist, even one that is thoroughly protected by high barriers to entry, can require consumers to purchase its product. Because the monopolist is the only firm in the market, its demand curve is the same as the market demand curve, which is, unlike that for a perfectly competitive firm, downward-sloping.
Figure 1 illustrates this situation. The monopolist can either choose a point like R with a low price Pl and high quantity Qh , or a point like S with a high price Ph and a low quantity Ql , or some intermediate point.
Setting the price too high will result in a low quantity sold, and will not bring in much revenue. Conversely, setting the price too low may result in a high quantity sold, but because of the low price, it will not bring in much revenue either. The challenge for the monopolist is to strike a profit-maximizing balance between the price it charges and the quantity that it sells.
See the following Clear it Up feature for the answer to this question. The demand curve as perceived by a perfectly competitive firm is not the overall market demand curve for that product. The reason for the difference is that each perfectly competitive firm perceives the demand for its products in a market that includes many other firms; in effect, the demand curve perceived by a perfectly competitive firm is a tiny slice of the entire market demand curve.
In contrast, a monopoly perceives demand for its product in a market where the monopoly is the only producer. Profits for a monopolist can be illustrated with a graph of total revenues and total costs, as shown with the example of the hypothetical HealthPill firm in Figure 2. The total cost curve has its typical shape; that is, total costs rise and the curve grows steeper as output increases.
To calculate total revenue for a monopolist, start with the demand curve perceived by the monopolist. Table 2 shows quantities along the demand curve and the price at each quantity demanded, and then calculates total revenue by multiplying price times quantity at each level of output. In this example, the output is given as 1, 2, 3, 4, and so on, for the sake of simplicity. If you prefer a dash of greater realism, you can imagine that these output levels and the corresponding prices are measured per 1, or 10, pills.
As the figure illustrates, total revenue for a monopolist rises, flattens out, and then falls. In this example, total revenue is highest at a quantity of 6 or 7. Clearly, the total revenue for a monopolist is not a straight upward-sloping line, in the way that total revenue was for a perfectly competitive firm.
The different total revenue pattern for a monopolist occurs because the quantity that a monopolist chooses to produce affects the market price, which was not true for a perfectly competitive firm. If the monopolist charges a very high price, then quantity demanded drops, and so total revenue is very low. If the monopolist charges a very low price, then, even if quantity demanded is very high, total revenue will not add up to much. At some intermediate level, total revenue will be highest.
However, the monopolist is not seeking to maximize revenue, but instead to earn the highest possible profit. Profits are calculated in the final row of the table. In the HealthPill example in Figure 2 , the highest profit will occur at the quantity where total revenue is the farthest above total cost. Of the choices given in the table, the highest profits occur at an output of 4, where profit is In the real world, a monopolist often does not have enough information to analyze its entire total revenues or total costs curves; after all, the firm does not know exactly what would happen if it were to alter production dramatically.
But a monopolist often has fairly reliable information about how changing output by small or moderate amounts will affect its marginal revenues and marginal costs, because it has had experience with such changes over time and because modest changes are easier to extrapolate from current experience.
A monopolist can use information on marginal revenue and marginal cost to seek out the profit-maximizing combination of quantity and price. The first four columns of Table 3 use the numbers on total cost from the HealthPill example in the previous exhibit and calculate marginal cost and average cost. This monopoly faces a typical upward-sloping marginal cost curve, as shown in Figure 3. The second four columns of Table 3 use the total revenue information from the previous exhibit and calculate marginal revenue.
Notice that marginal revenue is zero at a quantity of 7, and turns negative at quantities higher than 7. It may seem counterintuitive that marginal revenue could ever be zero or negative: after all, does an increase in quantity sold not always mean more revenue? For a perfect competitor, each additional unit sold brought a positive marginal revenue, because marginal revenue was equal to the given market price.
But a monopolist can sell a larger quantity and see a decline in total revenue. When a monopolist increases sales by one unit, it gains some marginal revenue from selling that extra unit, but also loses some marginal revenue because every other unit must now be sold at a lower price.
As the quantity sold becomes higher, the drop in price affects a greater quantity of sales, eventually causing a situation where more sales cause marginal revenue to be negative. A monopolist can determine its profit-maximizing price and quantity by analyzing the marginal revenue and marginal costs of producing an extra unit. If the marginal revenue exceeds the marginal cost, then the firm should produce the extra unit. For example, at an output of 3 in Figure 3 , marginal revenue is and marginal cost is , so producing this unit will clearly add to overall profits.
At an output of 4, marginal revenue is and marginal cost is , so producing this unit still means overall profits are unchanged. Production costs include every expense associated with making a good or service. They are broken down into two segments: fixed costs and variable costs.
Fixed costs are the relatively stable, ongoing costs of operating a business that are not dependent on production levels. They include general overhead expenses such as salaries and wages, building rental payments or utility costs. Variable costs , meanwhile, are those directly related to, and that vary with, production levels, such as the cost of materials used in production or the cost of operating machinery in the process of production. Total production costs include all the expenses of producing products at current levels.
As an example, a company that makes widgets has production costs for all units it produces. The marginal cost of production is the cost of producing one additional unit.
At some point, the company reaches its optimum production level, the point at which producing any more units would increase the per-unit production cost. In other words, additional production causes fixed and variable costs to increase. For example, increased production beyond a certain level may involve paying prohibitively high amounts of overtime pay to workers. Alternatively, the maintenance costs for machinery may significantly increase.
The marginal cost of production measures the change in the total cost of a good that arises from producing one additional unit of that good. Using calculus, the marginal cost is calculated by taking the first derivative of the total cost function with respect to the quantity:.
The marginal costs of production may change as production capacity changes. If, for example, increasing production from to units per day requires a small business to purchase additional equipment, then the marginal cost of production may be very high. In contrast, this expense might be significantly lower if the business is considering an increase from to units using existing equipment.
A lower marginal cost of production means that the business is operating with lower fixed costs at a particular production volume. If the marginal cost of production is high, then the cost of increasing production volume is also high and increasing production may not be in the business's best interests. Marginal revenue measures the change in the revenue when one additional unit of a product is sold.
The marginal revenue is calculated by dividing the change in the total revenue by the change in the quantity. In calculus terms, the marginal revenue MR is the first derivative of the total revenue TR function with respect to the quantity:. The total revenue is calculated by multiplying the price by the quantity produced. Marginal revenue increases whenever the revenue received from producing one additional unit of a good grows faster—or shrinks more slowly—than its marginal cost of production.
Increasing marginal revenue is a sign that the company is producing too little relative to consumer demand , and that there are profit opportunities if production expands.
Let's say a company manufactures toy soldiers. This is an example of increasing marginal revenue. For any given amount of consumer demand, marginal revenue tends to decrease as production increases. In equilibrium , marginal revenue equals marginal costs; there is no economic profit in equilibrium.
Markets never reach equilibrium in the real world; they only tend toward a dynamically changing equilibrium.
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