The following is an adapted excerpt from my book Microeconomics Made Simple: Basic Microeconomic Principles Explained in 100 Pages or Less.
The term “marginal revenue” refers to how much additional revenue a firm would earn from one additional unit of output.
EXAMPLE: Marty owns a small-scale ski park in a location far from any other site suitable for skiing (so, in Marty’s local market, his business is a monopoly). Because Marty has no competition, he can charge whatever price he wants for admission to his park, and he can test different prices to see which is the most profitable.
Calculating Marginal Revenue
Assuming that a monopoly must charge each customer the same price for its good, the monopoly faces a downward sloping marginal revenue curve — meaning that each additional unit the firm sells brings in less revenue than the unit before. The reason for this declining marginal revenue is that the firm must reduce the price it charges for its product if it wants to sell more units. And that new lower price would apply to all units sold — including all the units sold to buyers who would have been willing to pay a higher price.
EXAMPLE: The following figure shows the demand curve and the resulting marginal revenue curve for Marty’s ski park monopoly.
Demand and Marginal Revenue Curves for Marty’s Ski Park (Monopoly)
If he charges $50 for a day pass, Marty can sell 40 passes per day — for a total daily revenue of $2,000. Marty’s marginal revenue for the first 40 passes is $50 per pass.
If Marty reduces the price to $40, he can sell 80 passes per day — for a total daily revenue of $3,200. The marginal revenue for the 40 additional passes sold is $1,200 (i.e., $3,200 minus $2,000), or $30 per pass.
If Marty reduces the price further to $30, he can sell 120 passes each day — for a total daily revenue of $3,600. The marginal revenue for the additional 40 passes sold is $400 (i.e., $3,600 minus $3,200), or just $10 per pass.
Marty faces declining marginal revenue (i.e., each additional pass sold brings in less additional revenue than the previous pass) because when he reduces his price to sell more passes, he reduces the price that every visitor to the park pays — even those visitors who would have paid a higher price.
Note: As you can see in the above chart, for a monopoly, if the demand curve is a straight line, the marginal revenue curve will also be a straight line, with exactly twice the slope of the demand curve.
Maximizing Profit by Producing at MC = MR
Just like firms in other types of markets, monopolies choose to produce each unit for which marginal revenue exceeds marginal cost. That is, they produce up to the point at which marginal revenue is equal to marginal cost because this is the point at which the firm’s profit is maximized.