Download Why MR is below the Demand Curve

AP Economics
Name: ______________________
Marginal Revenue and Demand
If people will buy 100 units of a product when its price is $10.00, as the picture below illustrates, total revenue for
sellers will be $1,000. Simple geometry tells us that the area of the rectangle formed under the demand curve is found
by multiplying the height of the rectangle by its width. [ height = price , width = quantity]

Price * Quantity = Total Revenue
From total revenue, we can obtain a key concept of Microeconomics: marginal revenue. Marginal revenue is the
additional revenue added by selling an additional unit of output:
Marginal Revenue = (Change in total revenue) divided by (Change in sales)
According to the picture, people will not buy more than 100 units at a price of $10.00. To sell more, price must drop.
Suppose that to sell the 101st unit, the price must drop to $9.99.
What will the marginal revenue of the 101st unit be? (i.e. by how much will total revenue increase?)

There is a temptation to answer this question by replying, "$9.99."
A little arithmetic shows that this answer is incorrect. Total revenue when 100 are sold is $1,000. When 101 are sold,
total revenue is (101) x ($9.99) = $1,008.99.

The marginal revenue of the 101st unit is only $8.99
To see why the marginal revenue is less than price, one must understand the importance of the downward-sloping
demand curve. To sell another unit, sellers must lower price on all units.
They received an extra $9.99 for the 101st unit, but they lose $.01 on the 100 that they were previously selling.

So the net increase in revenue is the $9.99 minus the $1.00, or $8.99.
Price
Marginal
revenue
Demand
Quantity
0
The critical point to understand is that marginal revenue is less than price when a demand curve slopes downward.
(This means the MR curve is beneath the demand curve!)
Only when a demand curve is perfectly elastic (horizontal) does MR = P (i.e. is the demand curve = MR curve)
Price
Competitive Market
P
D = MR
Quantity
0
This means only a competitive market will have a Demand Curve = Marginal Revenue Curve. In all other market
structures the MR curve will always lie below the demand curve.
Price
Marginal
revenue
0
Demand
Quantity
Bottom Line of a downward sloping MR Curve
Since every firm maximizes profit when MR = MC, a downward sloping demand curve will have a direct impact on
both the quantity produced and the price charged. Basically all other firms----Monopoly, Oligopoly, Monopolistic
Competition, will produce LESS and charge more than a perfectly competitive market due to a MR Curve which lies
below their demand curve.