What happens to total revenue when a perfectly competitive firm sells additional units of output?

Pure or perfect competition is rare in the real world, but the model is important because it helps analyze industries with characteristics similar to pure competition. This model provides a context in which to apply revenue and cost concepts developed in the previous lecture. Examples of this model are stock market and agricultural industries.

1. Many sellers: there are enough so that a single seller’s decision has no impact on market price.

2. Homogenous or standardized products: each seller’s product is identical to its competitors’.

3. Firms are price takers: individual firms must accept the market price and can exert no influence on price.

4. Free entry and exit: no significant barriers prevent firms from entering or leaving the industry.

The individual firm will view its demand as perfectly elastic. A perfectly elastic demand curve is a horizontal line at the price. The demand curve for the industry is not perfectly elastic, it only appears that way to the individual firms, since they must take the market price no matter what quantity they produce. Therefore, the firm’s demand curve is a horizontal line at the market price.

Marginal revenue (MR) is the increase in total revenue resulting from a one-unit increase in output. Since the price is constant in the perfect competition. The increase in total revenue from producing 1 extra unit will equal to the price. Therefore, P= MR in perfect competition.

Short Run Analysis

In the short run, the firm has fixed resources and maximizes profit or minimizes loss by adjusting output. Firms should produce if the difference between total revenue and total cost is profitable (EP >0), or if the loss is less than the fixed cost (EP> - FC). The firm should not produce, but should shut down in the short run if its loss exceeds its fixed costs. By shutting down, its loss will just equal those fixed costs. Fixed cost in real life would be rent of the office, business license fees, equipment lease, etc. These cost would have to be paid with or without any output. Therefore, fixed cost would be the loss of shut down at any time. If by producing one unit of output, this loss could be lowered, then this unit should be produced to minimize the loss. However, if by producing one unit of output, this loss would be higher , then this unit should not be produced. The firm should shut down, just pay for the fixed cost.

If EP< - FC  firm should shut down. Then its lost will be the Fixed cost. EP = - FC. In order for EP < - FC, market price, P, must be lower than the minimum AVC.

If EP>- FC, firm should produce. That is when market price is greater than minimum AVC.

Marginal revenue and marginal cost (MC) are compared to decide the profit-maximizing output.

If MR > MC, then the firm should continue to produce.

If MR = MC, then the firm should stop producing the additional unit. As the additional unit’s MC would be higher according to law of diminishing returns, MR would be less than MC; that is, the firm would loss profit by producing additional units. Therefore, this is the profit maximizing output level.

If MR < MC, then the firm should lower its output.

In conclusion:

The shutdown point is the level of output and price at which the firm just covers its total variable cost. If the MR of the product is less than the minimum average variable cost (min AVC), the firm will shut down because this action minimizes the firm’s loss. In this case, the firm’s economic loss equals its total fixed costs. If MR < min AVC, then each additional unit produced would increase the loss. For pure competition, MR is equal to price as the firm is facing a perfectly elastic demand. Therefore, for short run, if Price < min AVC, then the firm should shut down. If Price > min AVC, then the firm should produce. Price and MC are compared to find the profit maximizing or loss minimizing output level. The supply curve of the pure competition firms would be the portion of the MC curve above the min AVC.

1. If EP < - FC or Market P < Min AVC, firm should shut down. Output = 0 , and EP = -FC

2. If EP > - FC or Market P > Min AVC, firm should produce. Firm's output level should be at where MR=MC or P=MC.  Use EP = TR - TC to get economic profit of the firm.

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Four Market Structures

The focus of this lecture is the four market structures. Students will learn the characteristics of pure competition, pure monopoly, monopolistic competition, and oligopoly. Using the cost schedule from the previous lecture, the idea of profit maximization is explored.

OBJECTIVES

1. Identify various market structures and their characteristics.

2. Be able to category firms into four market structures.

3. Describe the effects of imperfect competition upon the market and the firm.

4. Understand the pricing structure of the four structures.

TOPICS

Please read all the lectures by clicking on the following topics.

PERFECT COMPETITION

PERFECT COMPETITION CONT.

PERFECT COMPETITION EXAMPLE

PURE MONOPOLY

MONOPOLY EXAMPLE

PRICE DISCRIMINATION

MONOPOLISTIC COMPETITION

OLIGOPOLY

TECHNOLOGICAL DEVELOPMENT

ECONOMIC EFFICIENCY

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Marginal revenue is the increase in revenue that results from the sale of one additional unit of output. While marginal revenue can remain constant over a certain level of output, it follows from the law of diminishing returns and will eventually slow down as the output level increases. In economic theory, perfectly competitive firms continue producing output until marginal revenue equals marginal cost.

• Marginal revenue refers to the incremental change in earnings resulting from the sale of one additional unit.
• Analyzing marginal revenue helps a company identify the revenue generated from each additional unit sold.
• Marginal revenue is often shown graphically as a downward sloping line that represents how a company usually has to decrease its prices to drive additional sales.
• A company that is looking to maximize its profits will produce up to the point where marginal cost equals marginal revenue.
• When marginal revenue falls below marginal cost, firms typically do a cost-benefit analysis and halt production as it may cost more to sell a unit than what the company will receive as revenue.

Marginal revenue is a financial and economic calculation that determines how much revenue a company earns in revenue for each additional unit sold. As the price of a good is often tied to market supply and demand, a company's marginal revenue often varies based on how many units it has already sold.

Marginal revenue is useful in several contexts. Companies use historical marginal revenue data to analyze customer demand for products in the market. They also use the information to set the most effective and efficient prices. Last, companies rely on marginal revenue to better understand forecasts; this information is then used to determine future production schedules such as material requirements planning.

A company calculates marginal revenue by dividing the change in total revenue by the change in total output quantity. Ideally, the change in measurements captures the change from a single quantity to the next available quantity (i.e. the difference between the 100th and 101st unit sold). However, the formula above can still be used to capture the average marginal revenue across a series of units (i.e. the difference between the 100th and 115th unit sold).

The formula for marginal revenue can be expressed as:

Marginal Revenue = Change in Revenue Change in Quantity M R = Δ T R Δ Q \begin{aligned}\text{Marginal Revenue}&=\frac{\text{Change in Revenue}}{\text{Change in Quantity}}\\\\[-9pt]MR&=\frac{\Delta TR}{\Delta Q}\end{aligned} Marginal RevenueMR​=Change in QuantityChange in Revenue​=ΔQΔTR​​

For example, a company sells its first 100 items for a total of $1,000. If it sells the next item for $8, the marginal revenue of the 101st item is $8. Marginal revenue disregards the previous average price of $10, as it only analyzes the incremental change. If it sells a total of 115 units for $1,100, the marginal revenue for units 101 through 115 is $100, or $6.67 per unit.

Positive marginal revenue is informative, but it does not convey enough information to a company for smarter decision-making. Marginal transaction information should include expenses to garner the most insight.

Like other related concepts, marginal revenue can be graphically depicted. It is most often represented as a downward slowing straight line on a chart capturing price on the y-axis and quantity on the x-axis.

The marginal revenue curve is often downward sloping because there is most often an economically inverse relationship between price and quantity. As a company decreases the price of its product, more units will likely be demanded; as the price is increased, demand often decreases.

For this reason, a company must often decrease its price to increase its market share. By decreasing its price, the company will receive less marginal revenue for each additional unit sold. At some point, the market demand for additional units will drive the product price so low that it becomes unprofitable to manufacture additional units.

In the graph below, marginal revenue is depicted by one of the blue lines. The quantity in which marginal revenue and marginal cost intersect is the optimal quantity to sell; the associated price point is noted as bullet E (where quantity per period and demand intersect).

Marginal revenue can be analyzed by comparing marginal revenue at varying units against average revenue. Average revenue is simply the total amount of revenue received divided by the total quantity of goods sold.

In a perfect competition, marginal revenue is most often equal to average revenue. This is because collective market forces make each participant a price-taker. For example, the market may dictate that it is not profitable to sell a good below $10. However, charging more than $10 per unit puts a company at a disadvantage to other companies selling at that price.

In an imperfect competition, marginal revenue and average revenue will vary. This is because a firm must eventually lower its price to sell additional units. Both marginal revenue and average revenue tend to be downward sloping with marginal revenue often being the more steeper of the two lines. Consider an example where a company sells one good for $100. If it prices its second good at $90, its marginal revenue will be $90. However, its average revenue will be $95 (($100 + $90) / 2 units sold).

In the real world example shown graphically below, this is the theoretical average revenue and marginal revenue curve for an agricultural chemical producer in a monopolistic industry. Both marginal revenue and average revenue decrease as the firm lowers prices to sell more quantities, though marginal revenue decreases faster than average revenue.

The Economics of Food and Agriculture Markets

To assist with the calculation of marginal revenue, a revenue schedule outlines the total revenue earned, as well as the incremental revenue for each unit. The first column of a revenue schedule lists the projected quantities demanded in increasing order, and the second column lists the corresponding market price. The product of these two columns results in projected total revenues, in column three.

The difference between the total projected revenue of one quantity demanded and the total projected revenue from the line below it is the marginal revenue of producing at the quantity demanded on the second line. For example, 10 units sell at $9 each, resulting in total revenues of $90; 11 units sell at $8.50, resulting in total revenues of $93.50. This indicates the marginal revenue of the 11th unit is $3.50 ($93.50 - $90).

Any benefits gained from adding the additional unit of activity are marginal benefits. One such benefit occurs when marginal revenue exceeds marginal cost, resulting in a profit from new items sold. If the sale of one additional unit yields marginal revenue of $100 and marginal expenses of $80, the company will receive marginal profit of $20 for the additional item sold.

A company experiences the best results when production and sales continue until marginal revenue equals marginal cost. Beyond that point, the cost of producing an additional unit will exceed the revenue generated. If the company sells one additional unit for $100 but incurs marginal revenue of $105, the company will lose $5 in the process of selling that extra unit.

When marginal revenue falls below marginal cost, firms typically adopt the cost-benefit principle and halt production, as no further benefits are gathered from additional production.

A perfectly competitive firm can sell as many units as it wants at the market price, whereas the monopolist can do so only if it cuts prices for its current and subsequent units.

Marginal revenue for competitive firms is typically constant. This is because the market dictates the optimal price level and companies do not have much—if any—discretion over the price. As a result, perfectly competitive firms maximize profits when marginal costs equal market price and marginal revenue. Marginal revenue works differently for monopolies. For a monopolist, the marginal benefit of selling an additional unit is less than the market price. 

A firm's average revenue is its total revenue earned divided by the total units. A competitive firm’s marginal revenue always equals its average revenue and price. This is because the price remains constant over varying levels of output. In a monopoly, because the price changes as the quantity sold changes, marginal revenue diminishes with each additional unit and will always be equal to or less than average revenue.

Marginal revenue is calculated as the change in revenue divided by the change in quantity for any two given levels of sales. The closer the two levels of sales, the more meaningful and precise the marginal revenue calculation will be.

For example, imagine a company will make an additional $1,000 if it increases sales from 200 to 220 goods. The average marginal revenue received for each of these additional 20 units is $50/each. Should the company receive an additional $800 for increasing sales from 220 to 240, the average marginal revenue for these 20 units is $40/each.

Marginal revenue only considers income received and does not reflect any marginal expenses required to manufacture or sell the goods. Therefore, marginal revenue is different from profit.

Marginal revenue is the income gained by selling one additional unit, while marginal cost is the expense incurred for selling that one unit. Each measure the incremental change in dollars between varying levels of sales to determine at what level a company is most efficiently producing and selling goods.

Marginal revenue is important because it is a crucial indicator regarding the most idea level of activity a company should undertake. It is mathematically most ideal for a company to produce goods until marginal revenue is equal to marginal expenses; selling goods beyond this level usually means more expenses are incurred than revenue received for each good.

If marginal revenue is negative, this means total revenue falls as additional units are sold. This may be the result of a company needing to cut prices to sell those additional units. In this case, strictly looking at just marginal revenue, it is more ideal for a company to have sold less goods but for a higher average price as more revenue would have been received.

Regardless of its sector, industry, or product line, companies must be aware of how increasing sales quantities impacts marginal revenue. If the company must decrease prices to generate additional sales, marginal revenue will slowly decrease to the point where it is no longer profitable to sell additional goods.