Question

Is it possible for marginal revenue to be negative for a firm selling in a perfectly competitive market? Is it possible for marginal revenue to be negative for a firm selling in a monopolistically competitive market? Briefly explain.

Short answer

Marginal revenue cannot be negative in a perfectly competitive market, but could be negative in a monopolistically competitive market, though this scenario is uncommon.

Step-by-step solution

Perpectly Competitive Market

First, let's take a perfectly competitive market. In this market, each firm is a price taker since the market price is determined by the industry-wide demand and supply. The marginal revenue for a firm in a perfectly competitive market is equal to the market price. Since the price cannot be negative, the marginal revenue in a perfectly competitive market cannot be negative.

Monopolistically Competitive Market

In a monopolistically competitive market, a firm has some influence over the market price because of differentiated products. So, the price, and hence, revenue can drop if a firm chooses to sell more units (But only when the selling price of the additional unit is lower than the average revenue of previous units). Thus, it is possible for marginal revenue to be negative in a monopolistically competitive market, but it is an unusual scenario as firms want to maximize their profits.

Key concepts

Perfectly Competitive Market

In a perfectly competitive market, firms do not have control over the prices of their products. They are known as "price takers," which means they must accept the prevailing market price. This scenario occurs because there are many sellers offering identical products, and consumers can easily switch from one supplier to another.

A key characteristic of this market is that marginal revenue (MR) equals the market price. Marginal revenue is the additional income a firm earns from selling one more unit of a good. Since prices are determined by overall supply and demand, they cannot be negative. Thus, marginal revenue remains positive, matching the market price.

To summarize:

• Firms are price takers.
• Products offered are homogeneous.
• Marginal revenue equals market price.
• Marginal revenue is never negative.

Monopolistically Competitive Market

Monopolistically competitive markets share characteristics of both perfect competition and monopoly. Firms in this market face some degree of price-making ability due to product differentiation. Unlike a perfectly competitive market, products in a monopolistically competitive market are not identical; each firm offers a product with slight differences such as variations in quality, brand, or features.

These differences give firms some control over pricing, allowing them to set prices above the marginal cost. However, because there are still many competitors, if a firm sells additional units by significantly dropping prices, marginal revenue can fall even further than average revenue, leading to negative marginal revenue.

This situation, while possible, is rare because firms generally aim to increase profits, not operate at a loss. Key points to remember are:

• Firms have some price control due to differentiated products.
• Marginal revenue can become negative under certain conditions.

Differentiated Products

Differentiated products are a hallmark of monopolistically competitive markets. Unlike the identical products in perfectly competitive markets, differentiated products allow firms to distinguish themselves from competitors. This differentiation can be based on numerous factors:

• Product quality.
• Brand.
• Features or functionalities.
• Customer service or warranty terms.

These differences attract specific groups of consumers, enabling firms to charge varying prices for their unique offerings. As a result, product differentiation can lead to brand loyalty, and firms can to some extent influence their market share and pricing strategies. However, the existence of close substitutes means that firms are still subject to competitive pressures.

In short:

• Products differ among firms.
• Consumers perceive variations in quality or brand.
• Market dynamics allow for price adjustments and controlled pricing strategies.