The relationship between the price a company charges and the revenue gained from selling an additional unit is fundamental to microeconomic decision-making. While it may seem logical that selling an extra item generates revenue equal to its price, this equality only holds true under specific market conditions. Understanding when and why these two values—price (P) and marginal revenue (MR)—diverge is important for setting optimal production levels and pricing strategies.
Defining Price and Marginal Revenue
Price (P) is the amount of money a customer pays to acquire a single unit of a good or service. This value is the revenue generated per unit sold and is often referred to as Average Revenue (AR), as it represents the total revenue divided by the quantity sold. Price is the visible market signal consumers use to make purchasing decisions.
Marginal Revenue (MR) is an analytical calculation representing the change in a firm’s total revenue that results from selling one additional unit of output. It is the incremental income earned by increasing sales by a single unit. MR is derived by comparing the total revenue before and after the extra unit is sold, making it a dynamic measure used to evaluate the profitability of expanding production.
When Price and Marginal Revenue Are Equal: The Perfectly Competitive Market
The only market structure where price and marginal revenue are consistently equal is a perfectly competitive market. This market is characterized by a large number of sellers, identical products, and minimal barriers to entry. Firms operating here are considered “price takers,” meaning they cannot influence the market price and must accept the price determined by overall industry supply and demand.
For a firm in perfect competition, the demand curve is perfectly elastic, appearing as a horizontal line at the market price. Since the firm is a small part of the overall market, selling one more unit does not require lowering the price of any other unit. Therefore, the additional revenue generated by selling that extra unit (MR) is precisely equal to the established market price (P), resulting in the relationship P = MR.
When Price and Marginal Revenue Differ: Imperfect Competition
The equality of price and marginal revenue dissolves in the more common market structures known as imperfect competition. These markets include monopolies, oligopolies, and monopolistic competition, which grant firms some power over their pricing decisions. Because these firms sell differentiated products or represent a significant portion of the market, they are considered “price makers.”
Price makers face a downward-sloping demand curve, meaning they must lower the price of their product to sell a greater quantity. This necessity creates a divergence between price and marginal revenue. In any market with a downward-sloping demand curve, marginal revenue is always less than the price (MR < P) for every unit after the first. This relationship holds true because dropping the price to attract new buyers affects the revenue from all units sold, not just the last one.
Why Marginal Revenue Declines Faster Than Price
For any firm that must lower its price to sell more output, marginal revenue declines faster than the price due to the “price effect.” When a firm increases its sales volume by one unit, two things happen to total revenue simultaneously.
Output Effect
The firm gains revenue equal to the new, lower price for the additional unit sold.
Price Effect
The firm must also lower the price on all previous units that could have been sold at the higher price. This loss in revenue from pre-existing units must be subtracted from the revenue gained on the new unit when calculating marginal revenue.
For example, if a firm sells 5 units at \$10 (Total Revenue \$50), but must drop the price to \$9 to sell a 6th unit (Total Revenue \$54), the marginal revenue is only \$4. This is not the \$9 price of the 6th unit. The \$5 difference represents the lost dollar on each of the first five units now sold at \$9 instead of \$10.
Because the marginal revenue calculation incorporates this loss of revenue, the marginal revenue curve falls below the demand curve and is steeper. For a linear demand curve, the marginal revenue curve declines at twice the rate of the demand curve. This illustrates why the additional revenue gained from a sale is substantially less than the advertised price for firms that influence their market.
The Role of Marginal Revenue in Profit Maximization
The analysis of marginal revenue provides the framework for businesses to determine the optimal level of output to maximize profits. A fundamental principle of microeconomics states that a firm should increase production as long as the revenue gained from an additional unit exceeds the cost of producing that unit. Therefore, the profit-maximizing output level occurs where Marginal Revenue (MR) is exactly equal to Marginal Cost (MC).
If a firm produces where MR is greater than MC, increasing output will add more to revenue than to cost, raising the total profit. Conversely, if production occurs where MR is less than MC, the last unit produced reduced total profit, signaling the firm should decrease output.
Because price makers operate where MR is less than the price, they cannot simply produce where Price equals Marginal Cost, as a price taker does. Instead, the firm first uses the MR = MC rule to find the profit-maximizing quantity. It then looks up to the demand curve to determine the highest price consumers are willing to pay for that specific quantity.