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.

Read more about this topic:  Marginal Revenue

Famous quotes containing the words marginal, revenue, rule and/or thumb:

    “Most works of art are effectively treated as commodities and most artists, even when they justly claim quite other intentions, are effectively treated as a category of independent craftsmen or skilled workers producing a certain kind of marginal commodity.”
    —Raymond Williams (1921–1988)

    “If you tax too high, the revenue will yield nothing.”
    —Ralph Waldo Emerson (1803–1882)

    “The principle of majority rule is the mildest form in which the force of numbers can be exercised. It is a pacific substitute for civil war in which the opposing armies are counted and the victory is awarded to the larger before any blood is shed. Except in the sacred tests of democracy and in the incantations of the orators, we hardly take the trouble to pretend that the rule of the majority is not at bottom a rule of force.”
    —Walter Lippmann (1889–1974)

    “Your small hands, precisely equal to my own—
    only the thumb is larger, longer—in these hands
    I could trust the world, or in many hands like these,
    handling power-tools or steering-wheel
    or touching a human face ...”
    —Adrienne Rich (b. 1929)