Marginal Revenue - Relationship Between Marginal Revenue and Elasticity

Relationship Between Marginal Revenue and Elasticity

The relationship between marginal revenue and the elasticity of demand by the firm's customers can be derived as follows:

as

where e is the price elasticity of demand. If demand is inelastic (e < 1) then R' will be negative, because to sell a marginal (infinitesimal) unit the firm would have to lower the selling price so much that it would lose more revenue on the pre-existing units than it would gain on the incremental unit. If demand is elastic (e > 1) R' will be positive, because the additional unit would not drive down the price by so much. If the firm is a perfect competitor, so that it is so small in the market that its quantity produced and sold has no effect on the price, then the price elasticity of demand is negative infinity, and marginal revenue simply equals the (market-determined) price.

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