Limited Time Offer: Save 10% on all 2021 and 2022 Premium Study Packages with promo code: BLOG10    Select your Premium Package »

Price, Marginal Cost, Marginal Revenue,  Economic Profit, and the Elasticity of Demand

Price, Marginal Cost, Marginal Revenue, Economic Profit, and the Elasticity of Demand

Marginal revenue (MR) and marginal cost (MC) affect how a company makes its production decisions. Marginal cost (MC) refers to the increase in cost that is occasioned by the production of an extra unit. It is the additional cost of producing an additional unit.

Marginal revenue (MR) refers to the extra profit made by producing or selling an extra unit.

Perfect Competition

We’ll start with the perfect competition here because it is the easiest to understand. In perfect competition, each firm produces at a point where price (P) equals marginal revenue (MR) and average revenue (AR). As seen before, each firm does not make any economic profit in the long run. The quantity produced by each firm is also the point where the average cost (AC) equals marginal cost  (MC).

firm

industry

In a competitive market, individual buyers and sellers represent a very small share of total transactions made in the market. Therefore, they do not influence the prices of their products. Any individual firm is a price taker, and it is the market forces of demand and supply that determine the price.

In perfect competition, total revenue (TR) is equal to price times quantity for any given demand function. Mathematically it is represented as TR = P×Q. 

Each firm in a perfect competition does not make any economic profit in the long run; however, profit-maximizing firms will maximize profits when they produce Q quantities when MC=MR. The quantity produced by each firm is also the point where the average total cost (ATC) equals marginal cost (MC). Economic profit is maximized at the point at which marginal revenue (MR)=marginal cost(MC) in the short run, as indicated in the graph below.

It’s important to note that the profit maximization process occurs when total revenue (TR) exceeds total costs (TC) by a maximum amount, as shown below.

In a perfectly competitive market, individual buyers and sellers represent a very small share of total transactions made in the market. Therefore, they do not influence the prices of their products. Any individual firm is a price taker, and it is the market forces of demand and supply that determine the price resulting in a perfectly elastic demand as shown below;

The relationship between change in prices and change in quantities demanded is referred to as price elasticity. Total revenue is maximized when marginal revenue is zero; hence total revenue will only decrease when marginal revenue becomes zero. Therefore, the elasticity of demand in this regard shows that the percentage decrease in price is greater than the percentage increase in quantity demanded.

Monopolistic Competition

Goods produced under monopolistic competition are differentiated from one another by branding. It means that these firms have some control over their prices. However, raising these prices may cause some customers to shift to other products considered close substitutes. As a result, demand for these products will fall.

If a firm lowers the prices of its products, buyers will shift from buying other products and start buying its products. Consequently, the demand for the products will rise.

Generally, a firm under monopolistic competition can best be described by its elasticity (responsiveness) to demand. When demand is high, it increases the price of goods to maximize profit. It creates some supernormal profit, as seen in the graph below.

monopolistic-competition

A firm will likely maximize its profits if its marginal cost (MC) equals its marginal revenue (MR), as shown in the graph, and it will earn an economic profit when the price P1 is above the average cost C1.

On the other hand, when demand is low, the firm will lower its prices to win more customers. In the long run, other firms can also enter the market and compete to eliminate the supernormal profits. As a result, the profits of the monopolistic competitive firm will be normalized.

Oligopoly

Firms under this market structure are assumed to generally work towards the protection and maintenance of their share of the market. In other words, all firms may match one another’s prices. If one of the businesses raises its price, then a large substitution effect takes place. As a result, demand becomes relatively elastic.

oligopoly-kinked-demand-curve

From the above graph, the kink price is at P1 when the firm produces Q1. The firm anticipates that if the prices go above P1, the market competitors will maintain the prices at P1, resulting in a loss of market share.

Above P1, the demand curve is relatively elastic, i.e., an increase in price leads to a huge decrease in demand, while below P1, competitors will match the reduced prices, and therefore, the firm will maximize its profits at Q1.

The marginal revenue associated with each demand structure also differs in the oligopoly, and each is synonymous with a different part of the kinked demand curve.

The level of output that maximizes profit occurs where marginal revenue (MR) is equal to marginal cost (MC), that is, MR=MC as indicated in the graph above.

Monopoly

Since only one firm controls the whole market for a monopoly, the demand curve will be the average revenue curve (AR=D). The quantity that the monopolist will produce is when marginal revenue equals marginal cost (MR=MC), just like in perfect competition, the profit-maximizing output.

However, since the marginal and average revenue curves are separate, the monopolist will charge the price PM at the top as illustrated in the graph below;

Since the monopolist produces QC but charges the price PC, this creates a “box” of supernormal profit from PM to PC and QM to QC.

In this form of market, the demand is relatively inelastic. It means that consumers buy about the same amount whether the price drops or rises. The monopolist needs to lower their prices by offering bundles or discounts to produce more.

Question

Over time, the market share of a dominant oligopoly firm:

  1. increases.
  2. decreases.
  3. remains constant.

Solution

The correct answer is B.

Over time, the profits made by the dominant oligopoly firm will attract more investors or companies to the industry. Therefore, the market share of the dominant firm will decrease.

 

Featured Study with Us
CFA® Exam and FRM® Exam Prep Platform offered by AnalystPrep

Study Platform

Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Online Tutoring
    Our videos feature professional educators presenting in-depth explanations of all topics introduced in the curriculum.

    Video Lessons



    Sergio Torrico
    Sergio Torrico
    2021-07-23
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    diana
    diana
    2021-07-17
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    2021-07-16
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    2021-06-28
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Marwan
    Marwan
    2021-06-22
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    2021-05-10
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.