Why Is Marginal Revenue Less Than Price In A Monopoly

Why is Marginal Revenue Less Than Price in a Monopoly? A Comprehensive Explanation

Understanding the relationship between marginal revenue (MR) and price (P) is crucial for grasping the economic behavior of firms, particularly monopolies. While in perfectly competitive markets, firms are price takers and MR equals P, monopolies, as price makers, face a downward-sloping demand curve. This leads to a fundamental difference: in a monopoly, marginal revenue is always less than price. This article will delve into the reasons behind this, exploring the underlying economics and providing illustrative examples.

The Downward-Sloping Demand Curve: The Foundation of the Discrepancy

The core reason why MR < P in a monopoly stems from the monopolist's downward-sloping demand curve. Unlike perfectly competitive firms that can sell any quantity at the prevailing market price, a monopoly faces a trade-off: to sell more units, it must lower the price not only on the additional units but also on all previously sold units.

This is a direct consequence of the monopolist's market power. Because it's the sole supplier, it doesn't have to compete with other firms on price. However, this power comes with a crucial constraint: the law of demand. The law of demand states that as the price of a good decreases, the quantity demanded increases, ceteris paribus.

Illustrative Example:

Imagine a monopolist selling widgets. Let's say at a price of $10, they sell 100 widgets. To sell 110 widgets, they might have to reduce the price to $9.50. This is where the crucial difference emerges. The additional revenue from selling those extra 10 widgets ($9.50 x 10 = $95) is the marginal revenue. However, the revenue gained is not just $95. The monopolist also loses revenue from selling the original 100 widgets at a lower price ($0.50 x 100 = $50).

Therefore, the total marginal revenue from selling 110 widgets instead of 100 is $95 - $50 = $45. This illustrates that marginal revenue ($45) is significantly less than the price of the last unit sold ($9.50).

The Mathematical Relationship

The relationship between marginal revenue and price can also be demonstrated mathematically. The total revenue (TR) is the product of price (P) and quantity (Q):

TR = P x Q

Marginal revenue (MR) is the change in total revenue resulting from a one-unit change in quantity:

MR = ΔTR/ΔQ

Since the monopolist faces a downward-sloping demand curve, to sell an additional unit, it must lower the price of all units sold. This price reduction reduces the revenue gained from the previously sold units, resulting in MR being less than P.

The Importance of Elasticity of Demand

The extent to which MR falls below P is influenced by the price elasticity of demand. Price elasticity of demand measures the responsiveness of quantity demanded to a change in price.

• Inelastic Demand: When demand is inelastic (a small change in price leads to a small change in quantity demanded), the price reduction needed to sell an additional unit is relatively small. Consequently, the reduction in revenue from previously sold units is also small, and MR will be closer to P.

• Elastic Demand: When demand is elastic (a small change in price leads to a large change in quantity demanded), the price reduction needed to sell an additional unit is relatively large. This leads to a substantial reduction in revenue from previously sold units, causing MR to be significantly less than P.

Implications for Monopoly Pricing and Output

The fact that MR < P has significant implications for a monopolist's pricing and output decisions. A profit-maximizing monopolist will always produce where marginal revenue equals marginal cost (MR = MC). Since MR < P, this means the monopolist will charge a price that is higher than its marginal cost. This results in:

• Higher Prices: Monopolists charge higher prices compared to perfectly competitive markets, leading to a welfare loss.

• Lower Output: Monopolists produce a lower quantity of goods compared to what would be produced under perfect competition, resulting in allocative inefficiency.

• Deadweight Loss: The difference between the socially optimal quantity (where P = MC) and the quantity produced by the monopolist represents a deadweight loss – a loss of potential economic welfare.

Comparing Monopoly to Perfect Competition

The difference between MR and P is a fundamental distinction between monopoly and perfect competition. In perfect competition, firms are price takers, facing a perfectly elastic demand curve (horizontal line). This means they can sell any quantity at the prevailing market price. Therefore, the marginal revenue of selling an additional unit is simply the market price: MR = P.

This contrast highlights the key difference in market power: competitive firms have no market power, while monopolies possess substantial market power, allowing them to influence price but at the cost of reducing marginal revenue below the price.

Beyond Simple Models: Real-World Considerations

The MR < P relationship holds true in the simplest models of monopoly. However, in the real world, several factors can complicate this relationship:

• Price Discrimination: If a monopolist can successfully practice price discrimination (charging different prices to different consumers), the relationship between MR and P becomes more complex. For example, if a monopolist can perfectly price discriminate, its MR will equal its price for each unit sold.

• Multiple Products: Monopolists often produce multiple products. The demand and cost conditions for each product will influence the relationship between MR and P for each product individually.

• Dynamic Pricing: In many industries, prices are not static. Monopolies may adjust prices over time to respond to changing market conditions or demand. This dynamic pricing can further complicate the MR-P relationship.

• Government Regulation: Government intervention, such as price ceilings or antitrust laws, can affect the monopolist's ability to set prices and thereby change the MR-P relationship.

Conclusion: Understanding the Power of Market Imperfection

The fact that marginal revenue is always less than price in a monopoly is a direct consequence of its downward-sloping demand curve. This fundamental characteristic has significant implications for the monopolist's pricing, output decisions, and overall market efficiency. Understanding this relationship is crucial not only for economists but also for policymakers seeking to regulate monopolies and promote greater market competition. The complexities introduced by real-world factors emphasize the need for a nuanced understanding of monopoly behavior, moving beyond simplistic models to incorporate the dynamic and often unpredictable nature of markets. This knowledge provides a robust framework for analyzing market imperfections and their effects on society.