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Lesson 1 of 9 · 12 min

Revenue, economic profit and the MR = MC rule

Every firm maximizes profit by producing where marginal revenue equals a rising marginal cost; what differs across markets is whether marginal revenue equals the price or falls below it.

Video lesson · 6 min. Watch it first, then use the text below to go deeper.

In short

A firm in perfect competition is a price taker: it faces a horizontal demand curve, so price = average revenue (AR) = marginal revenue (MR).
A firm in imperfect competition faces a downward-sloping demand curve: to sell one more unit it must cut the price on all units, so MR < price.
Profit is maximized where MR = MC and MC is not falling. The price is then read off the demand curve.
Economic profit = TR − all economic costs, including opportunity costs. Accounting profit = TR − explicit (accounting) costs only.
Zero economic profit is a normal profit: the firm earns exactly what its capital and other resources could earn in their next best use.

The demand curve the firm faces

In perfect competition each firm is tiny relative to the market and sells an identical product. It must accept the market price, so it can sell as much as it wants at that price and nothing above it. Its demand curve is perfectly elastic (horizontal).

Because every extra unit sells at the same price, total revenue $TR = P \times Q$ is a straight line through the origin with slope P. Marginal revenue, the extra revenue from one more unit, equals the price, and so does average revenue (TR ÷ Q).

A firm with pricing power, such as a monopolist, faces a downward-sloping demand curve. Price depends on how much it sells, $P = f(Q)$ . To sell one more unit it must lower the price on every unit it sells, so MR is below the price.

Its TR curve is hump-shaped. At first, cutting the price raises TR because the extra units outweigh the lower price: demand is elastic and MR is positive. Past the top of the hump, further price cuts reduce TR: demand is inelastic and MR is negative.

	Perfect competition	Imperfect competition
Demand facing the firm	Horizontal at market price	Downward sloping
Price and MR	P = AR = MR	P = AR > MR
TR curve	Straight line, slope = P	Rises, peaks where MR = 0, then falls
Pricing power	None (price taker)	Some to considerable (price searcher)

The price taker's TR rises by the same 30 on every unit. The monopolist facing

P = 100 - 2Q

gains revenue only while demand is elastic (left of 25); beyond the peak, MR is negative and selling more lowers TR.

The profit-maximizing rule: MR = MC

Producing one more unit adds MR to revenue and MC to cost. As long as MR > MC, the extra unit adds to profit, so the firm should expand. If MR < MC, the last unit lost money, so it should cut back. Profit peaks where MR = MC.

There is a second condition: MC must not be falling at that point. Where a falling MC curve crosses MR, the next units cost less than they bring in, so expanding further still raises profit. The optimum is where a rising MC cuts MR.

For a price taker MR = P, so the rule becomes P = MC. If the market price rises, the firm's horizontal demand line shifts up and it produces more; if the price falls, it produces less. That is why a competitive firm's (rising) MC curve is its supply curve.

For a firm with pricing power, the rule gives the quantity Q*; the price P* is the highest price buyers will pay for Q*, read from the demand curve, not from MR or MC. Whether the firm earns a profit then depends on whether P* is above average total cost (ATC) at Q*.

Monopolist with

P = 100 - 2Q

and MC = 10 + 2Q. Output comes from MR = MC (Q* = 15), the price from the demand curve (70). Price exceeds ATC by 25 per unit, so economic profit is 25 × 15 = 375.

Economic profit versus accounting profit

Accounting profit subtracts only explicit costs: wages, materials, rent, interest. Economic profit also subtracts implicit opportunity costs, the value of the owner's time and capital in their next best use. Opportunity cost is the value of the best alternative given up.

A firm whose revenue just covers all economic costs earns zero economic profit, called a normal profit. Its capital earns exactly the return investors could get on an equally risky alternative. It can still report a healthy accounting profit.

When economic profit is positive and entry is easy, the extra return attracts new firms. Their extra output drives the price down until, in the long run, firms earn only a normal profit. Barriers to entry are what let some firms keep economic profit.

'Zero economic profit' sounds like failure but is not. It means the business pays every input, including the owner's capital, its going rate. Nobody has a reason to leave, and nobody has a reason to enter.

Formulas

Total, average and marginal revenue: $TR = P \times Q \qquad AR = \frac{TR}{Q} = P \qquad MR = \frac{\Delta TR}{\Delta Q}$
In perfect competition MR = AR = P. With a downward-sloping demand curve, MR < P.
Profit maximization: $MR = MC \quad \text{(with MC not falling)}$
Gives the optimal quantity. Under perfect competition it reduces to P = MC.
Economic profit: $\text{Economic profit} = TR - (\text{explicit costs} + \text{implicit opportunity costs})$
Accounting profit subtracts explicit costs only. Zero economic profit = normal profit.

Worked examples

Example 1 A price taker's output and profit

A wheat farm sells at the market price of EUR 50 per tonne. Its total cost is $TC = 300 + 10Q + Q^2$ , so MC = 10 + 2Q. What output maximizes profit, and what is the economic profit?

Example 2 A monopolist's price and output

A firm facing demand $P = 100 - 2Q$ has the same cost function, TC = 300 + 10Q + $Q^2$ . Find its profit-maximizing quantity, price and economic profit.

Example 3 Economic versus accounting profit

A bakery owner in Zurich has revenue of CHF 900,000 and explicit costs of CHF 650,000. She gave up a CHF 120,000 salary elsewhere and CHF 80,000 a year she could have earned on her capital. Compute accounting and economic profit.

On the exam

Expect items on P = MR under perfect competition versus MR < P otherwise, on the MR = MC rule (often 'which condition is least likely a profit maximum'), and on economic versus normal profit.

Reading the monopolist's price off the MR or MC curve. Output comes from MR = MC; price comes from the demand curve.
Thinking profit is maximized where ATC is lowest. Minimum ATC is about cost efficiency, not about where MR = MC.
Treating zero economic profit as zero accounting profit. A firm earning a normal profit usually reports a positive accounting profit.
Accepting an MR = MC crossing where MC is still falling. Profit keeps rising past that point.

Check yourself

Q1A wheat farm in a perfectly competitive market raises its output and sales by 8%. Its total revenue will most likely rise by:
Q2A monopolist faces demand $P = 120 - 3Q$ and a constant marginal cost of EUR 30. Its profit-maximizing price is closest to:
Q3A firm has revenue of CHF 900,000, explicit costs of CHF 650,000, a forgone salary of CHF 120,000 and a forgone return on capital of CHF 80,000. Its economic profit is:
Q4A profit maximum is least likely to occur where:
Q5A firm that is earning a normal profit is most likely:
Q6In the range where a monopolist's marginal revenue is negative, cutting the price will:

0/6Check yourself

Answer the 6 questions: +10 XP for each one you get right first time.

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