Explain the relationship, under conditions of perfect competition, between (a) total revenue and marginal revenue, (b) total revenue and average revenue and (c) average revenue and marginal revenue.
Answers
Total revenue refers to the total sale proceeds of a firm by selling its total output at a given price. Mathematically TR = PQ, where TR = Total Revenue, P = Price, Q = Quantity sold. Suppose a firm sells 100 units of a product at the price of $5 each, the total revenue will be 100 × $5 = $500.
Average Revenue
Average revenue is the revenue per unit of the commodity sold. It is obtained by dividing the total revenue by the number of units sold. Mathematically AR = TR/Q; where AR = Average revenue, TR = Total revenue and Q = Quantity sold. In our example, average revenue is = 500/100 = $5. Thus, average revenue means price.
Marginal Revenue
Marginal revenue is the addition to total revenue by selling one more unit of the commodity.
Algebraically it is the total revenue earned by selling ‘n’ units of the commodity instead of n-1. Thus,
MRn = TRn – TRn-1; where MRn = Marginal revenue of the nth unit
TRn = Total revenue of n units
TRn-1 = Total revenue of n-1 units
N = Any given number of units sold.
Suppose 5 units of a product are sold at a revenue of $50 and 6 units are sold at a total revenue of $60. The marginal revenue will be $60 - $50 = $10. It implies that the 6th unit earns an additional income of $10.
Relationship between AR and MR curve
Let us consider the relationship between marginal, average and total revenue under pure completion and under imperfect competition.
1. Under Pure competition
Under pure (or perfect) competition, a very large number of firms are assumed to be present. The supply of each seller is just like a drop of water in a mighty ocean so that any increase or decrease in production by any one firm exerts no perceptible influence on the total supply and on the price in the market. The collective forces of demand and supply determine the price in the market so that only one price tends to prevail for the whole industry. Each firm has to take the market price as given and sell its quantity at the ruling market price. In simple terms, the firm is a ‘price-taker’ and the firm’s demand curve is infinitely elastic. As the firm sells more and more at the given price, its total revenue will increase but the rate of increase in the total revenue will be constant, since AR = MR.