Marginal revenue and marginal cost in imperfect competition | APⓇ Microeconomics | Khan Academy

In this video, we're going to think about marginal revenue and marginal cost for a firm in an imperfectly competitive market. But before we do that, I just want to be able to review and compare to what we already know about a firm in a perfectly competitive market.

So right over here, we're analyzing the firm's economics. This shows the marginal cost as a function of quantity, and we've talked about this before. Oftentimes, it will trend down initially as you have better specialization and some efficiencies, and then it might start trending up as there are just coordination costs or other costs that make the marginal cost go up. We have talked about this notion that in a perfectly competitive market, the firm is a price taker.

There's going to be some market price, let's call this P sub M, some price in the market for the good that they are producing. There are many producers who are producing this good, and they're undifferentiated, and there are no barriers to entry. So, they just have to be price takers. No matter how many units they produce, they're just going to be able to get that same market price.

So, a firm in a perfectly competitive market, that market price defines their marginal revenue curve. Their marginal revenue curve will essentially just be a horizontal line like this. We've already studied this in previous videos, and we talked about that here if this firm was trying to maximize its profit. If it was rational, it would produce the quantity where marginal cost is equal to marginal revenue. So, it would produce this quantity right over here.

But now let's think about how things are a bit different for a firm in an imperfectly competitive market. In a previous video, we talked about how in an imperfectly competitive market, there's some differentiation amongst the various players who are competing. Their market price is a function of quantity. If they just produce a bunch of their product, the price that they get in the market is likely to go down. So, they will have their own firm-specific demand curve; maybe it looks something like this.

So, that is their demand curve. We also saw in that video that that demand curve essentially shows the price they could get at any quantity. That's not going to be the same as a marginal revenue curve. If the demand curve is downward sloping like that, the marginal revenue curve is likely to be even more downward sloping. So, it's going to look something like this. That would be the marginal revenue curve.

Now, in this situation, what would be rational for the firm to do? Well, once again, it would want to produce the quantity where the marginal cost is equal to the marginal revenue. So, they would want to produce this quantity right over here. But you see something interesting here; if they produce at this quantity, notice the price that they can get in the market is much higher than that. The price that they get in the market is higher than the marginal cost and the marginal revenue at that point.

Because we see a situation where price is greater than your marginal cost, versus in a perfectly competitive market where you see that price is equal to marginal cost, that is the optimal quantity. But because you have this gap, that people are willing to pay more than that marginal cost, you still aren't going to be able to produce any more because it doesn't make sense from a marginal revenue point of view.

This gap, the difference between the price and the marginal cost at this rational quantity for this firm in an imperfectly competitive market to produce, economists would refer to this as an inefficiency. Inefficiency! Folks are willing to pay more than that marginal cost, but you still have no motivation to produce more. Because if you produce more, even though the price is higher than the marginal cost, your marginal revenue is going to be below the marginal cost, and so you would be taking a hit in aggregate on those extra units.