Simple Economics on the Web
Your handy guide to economics
Firms with Market Power
Unlike perfect competitors, producers with Market Power face a downward sloping demand curve. Where perfect competitors must accept the market price, a producer with market power can set their price by adjusting their level of output – i.e. by choosing the point on the demand curve where they want to operate.
The producer will make this decision so as to maximize profits. One part of the profit maximizing decision is the behavior of revenue as the level of output changes. Earlier, we saw how a straight-line demand curve becomes less elastic as output increases. In the curves below, we translate this finding into the behavior of revenue as output increases. In viewing these curves, recall that when a demand curve is elastic at a particular point, increasing output (and lowering the price) will increase revenue.
In terms of business strategy, the central concept here is Marginal Revenue - the change in revenue (positive or negative) per unit increase in output. The relationship between Marginal Revenue, Price and demand elasticity (e) is summarized in the formula:
The formula indicates that when demand is elastic – say, e = - 3.5 – Marginal Revenue is positive. Both concepts are saying that at this point, selling more output (at a lower price) causes revenue to rise. Conversely, if demand is inelastic – e = -.75 – Marginal Revenue is negative. Here, both concepts are saying that at this point, selling more output at a lower price will cause revenue to decline.
Using the orange quantity button, show how increases in output first cause revenue to rise and then fall .Watch the evolution of Marginal Revenue through this process.
Question: Using your knowledge of elasticity, what should be the value of elasticity at the point on the demand curve where revenue is maximized? What should be the value of Marginal Revenue at this point?