What this lesson teaches
I can explain a firm's cost and revenue concepts in the short run and the long run.
Syllabus 9570, 2.2.2(a). Cost and Revenue: Firms' cost and revenue concepts in the short run and long run
Make a guess
A bakery sells 20 cakes a day at $10. To sell 21, it must cut the price to $9.50 on every cake. How much does the 21st cake add to revenue?
- $9.50, the price of the 21st cake.
- $10, the old price of a cake.
- Nothing: revenue falls by $0.50.
Show the answer
Nothing: revenue falls by $0.50.
Revenue goes from $200 to $199.50. The 21st cake brings in $9.50, but the bakery loses $0.50 on each of the other 20 cakes, which is $10.
AR is the price. MR, the revenue from one more unit, is below the price when the firm must cut prices to sell more.
Total revenue (TR) = price x quantity.
Average revenue (AR) = TR / quantity, which is the price. So the AR curve is the firm's demand curve.
Marginal revenue (MR) is the extra revenue from selling one more unit.
If the firm must cut its price to sell more, it cuts the price on every unit, not just the extra one. So MR is less than the price, and the MR curve lies below AR. For a straight-line AR, MR falls twice as steeply.
- AR
- TR / Q = price; the demand curve.
- MR
- Extra revenue from one more unit.
- MR below AR
- When the price must fall to sell more.
Worked example: Selling one more unit
A firm can sell 4 units at $12 each, or 5 units at $11 each.
- TR at 4 units: $48. TR at 5 units: $55.
- MR of the 5th unit: $55 - $48 = $7.
- The 5th unit sells for $11, but the firm loses $1 on each of the other 4 units: $11 - $4 = $7.
- AR at 5 units is $55 / 5 = $11, the price.
Watch out for this
Marginal revenue is always equal to the price.
Only for a price taker. A firm that must cut its price to sell more loses revenue on its other units, so MR is below the price.
Check your understanding
A shop sells 10 items at $20. To sell 11, it must cut the price to $19 on all items. What is the MR of the 11th item?
- $209.
- $19.
- $9.
Show the answer
$9.
Right. TR goes from $200 to $209, so MR = $9.