The decision of how much to produce and what price to set is a fundamental challenge for any business. Microeconomic theory provides a framework for optimizing these decisions, focusing on the relationship between the price received per unit and the change in total revenue from selling an additional unit (Marginal Revenue). Understanding whether the price of a product equals the extra revenue generated is important for strategic planning, as this relationship depends heavily on the competitive environment. Misunderstanding this distinction can lead to lost profits and inefficient resource allocation.
Defining Price and Marginal Revenue
Price ($P$) is the monetary amount a business receives for the sale of a single unit. It represents the average revenue per unit sold. For example, if a company sells 100 units at $10 each, the price is $10, and the total revenue is $1,000.
Marginal Revenue ($MR$) is the change in a firm’s total revenue that results from selling one additional unit of output. To calculate $MR$, subtract the total revenue before the sale of the last unit from the total revenue after the sale. For instance, if selling 10 units yields $100 in total revenue, and selling the 11th unit increases total revenue to $108, the marginal revenue of that 11th unit is $8.
When Price Equals Marginal Revenue
The condition where price equals marginal revenue ($P = MR$) is unique to perfect competition. This theoretical market structure is characterized by a very large number of small firms, none of which can individually influence the market price. All firms sell a homogeneous product, meaning consumers perceive no difference between sellers.
Because firms are small relative to the entire market, they are “price takers” forced to accept the market-determined price. A single firm can sell any quantity at the prevailing market price without causing the price to drop. Consequently, the demand curve facing an individual firm is perfectly elastic, appearing as a horizontal line at the market price level.
In this scenario, selling one additional unit adds revenue exactly equal to the existing price, because the firm does not have to lower the price on previously sold units. If the market price is $5, selling the 100th unit adds $5 to total revenue, and selling the 101st unit also adds $5. Marginal revenue is consistently equal to the price ($P = MR$). This equality simplifies revenue analysis, as the absence of market power ensures the revenue generated by the last unit sold is undiminished.
When Price Does Not Equal Marginal Revenue
In most real-world markets, the price a firm charges is not equal to the marginal revenue generated by the last unit sold. This inequality ($MR < P$) defines imperfect competition. This category includes monopolies, oligopolies (a few large firms), and monopolistic competition (many firms selling differentiated products).
Firms in these structures possess market power, allowing them to influence the price of their goods, earning them the designation of "price setters." They do not face the horizontal demand curve of perfect competition. Instead, they face the market demand curve, which slopes downward.
A downward-sloping demand curve means that to sell a higher quantity, the firm must lower the price to attract new buyers. For example, a company might sell 10 units at $20, but to sell 11 units, it must drop the price to $19 for all units. The price of the 11th unit is $19, but the marginal revenue will be less than $19 because of the revenue sacrifice made on the first 10 units. This necessary price reduction is the fundamental reason for the divergence between $P$ and $MR$.
The Economic Reason Marginal Revenue Falls Faster Than Price
Marginal revenue falls faster than price for a price-setting firm due to the interaction of two consequences when output increases. When the firm lowers its price to sell an additional unit, it experiences the output effect: the positive change in total revenue from selling that extra unit at the new, lower price. If a firm sells 10 units at $10 and lowers the price to $9 for the 11th unit, the output effect is the $9 received from the new sale.
The firm must also contend with the price effect: the negative consequence of applying that lower price to all units previously sold at the higher price. In the example, the firm loses $1 of revenue on each of the first 10 units, resulting in a total revenue loss of $10. This lost revenue must be subtracted from the revenue gained from the new unit to calculate the true marginal revenue.
To illustrate, 10 units at $10 yield $100 in total revenue. When the price is lowered to $9, 11 units yield $99. The marginal revenue of the 11th unit is $99 minus $100, or negative $1. Although the price of the 11th unit is $9, the marginal revenue is significantly lower because the $9 gain from the output effect is overwhelmed by the $10 loss from the price effect. This demonstrates that the marginal revenue curve for a price setter always lies below the demand curve, causing $MR$ to decline faster than $P$.
Practical Application for Business Strategy
The difference between price and marginal revenue has direct implications for business strategy, particularly in production and pricing decisions. All firms, regardless of market structure, adhere to the rule for profit maximization: they should produce the quantity of output where marginal revenue equals marginal cost ($MR = MC$). Marginal cost represents the cost of producing the last unit, and equating it with the revenue from that unit defines the optimal point.
A firm in an imperfectly competitive market ($P > MR$) must use the calculated marginal revenue for this equation. If the firm mistakenly uses the higher price ($P$) instead of $MR$ in the profit-maximizing formula, it will produce a quantity greater than the optimal level. This overproduction means the cost of the last unit produced ($MC$) will exceed the revenue generated by that unit ($MR$), reducing total profit. Accurately assessing the market structure to determine the true relationship between price and marginal revenue is the first step toward setting efficient production levels and achieving profit optimization.