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:

    “Of course I’m a black writer.... I’m not just a black writer, but categories like black writer, woman writer and Latin American writer aren’t marginal anymore. We have to acknowledge that the thing we call “literature” is more pluralistic now, just as society ought to be. The melting pot never worked. We ought to be able to accept on equal terms everybody from the Hassidim to Walter Lippmann, from the Rastafarians to Ralph Bunche.”
    —Toni Morrison (b. 1931)

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

    “As a rule they will refuse even to sample a foreign dish, they regard such things as garlic and olive oil with disgust, life is unliveable to them unless they have tea and puddings.”
    —George Orwell (1903–1950)

    “I had a consuming ambition to possess a miller’s thumb. I believe I have never since wanted anything more desperately than I wanted my right thumb to be flattened as my father’s had become, during his earlier years of a miller’s life.”
    —Jane Addams (1860–1935)