Marginal Revenue - Marginal Revenue and Rule of Thumb Pricing

Marginal Revenue and Rule of Thumb Pricing

Profit maximization requires that a firm produce where marginal revenue equals marginal costs. Firm managers are unlikely to have complete information concerning their marginal revenue function or their marginal costs. Fortunately the profit maximization conditions can be expressed in a “more easily applicable form” or rule of thumb.

R' = C'

R' = (1 + 1/e)

MC = (1 + 1/e)

MC = + /e

( - C')/ = - 1/e

Markup is the difference between price and marginal cost. The formula states that markup as a percentage of price equals the negative of the inverse of elasticity of demand.Alternatively, the relationship can be expressed as:

= C'/(1 + 1/e)

Thus if e is - 2 and MC is $5.00 then price is $10.00.

( - C')/ = - 1/e is called the Lerner index after economist Abba Lerner. The Lerner index is a measure of market power - the ability of a firm to charge a price that exceeds marginal cost. The index varies from zero to 1. The greater the difference between price and marginal cost the closer the index value is to 1. The Lerner index increases as demand becomes less elastic.

Real life example: if you can sell 10 units at $20 each or 11 units at $19 each, then your marginal revenue from the eleventh unit is (11 × 19) - (10 × 20) = $9.