Saturday, June 24, 2006

Marginal Revenue

If there is one concept in economics that does not get recognized as being critical, it is that of marginal revenue. I just got done teaching a bunch of smart undergrads in Tuck's Business Bridge Program, and to a great extent much of my seven sessions is built around the idea of marginal revenue.

The key idea is this: if you want to sell more units, you have to lower the price. What happens to your total revenue as you lower your price? Well, there are two offsetting effects: one, you get more revenue by selling more units (at the new price). This is money from home. But the second effect is that you lower the price on units you would have sold anyway. This second effect reduces revenue, and overall, your marginal revenue is the sum of the two.

Think of Apple and Itunes. If the price per song is reduced, Apple will no doubt sell more songs than it otherwise would have. But it will also reduce price on all the songs it would have sold anyway. 0

Playing around with examples is really instructive. The net effect depends on things like the slope of the demand curve, and what the level of current sales is. And of course, all this is summarized by the elasticity of demand, but just jumping to elasticity tends to make one lose sight of what is really going on.

The application of marginal revenue that is on my mind now involves the decision to increase in production capacity in an oligopoly. Suppose there is an industry with only a few firms. If one firm adds more capacity, it will pick up some additional units of sales...but no doubt it will also cause a decline in price for the units that the firm could have sold anyway. To think of an equilibrium in investment for such an industry, we need to invoke the idea of a Nash equilibrium...and the thing that will drive that equilibrium will be the two effects discussed above: the revenue from addtional capacity versus the effect on "inframarginal" sales.

Why micro textbooks don't emphasize this more is beyond me. The applications to pricing alone are worth several chapters.

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