What is the relation between marginal revenue curve and demand curve under monopolistic competition?

The marginal revenue curve reflects the degree of market control held by a firm. For a perfectly competitive firm, the marginal revenue curve is a horizontal, or perfectly elastic, line. For a monopoly, oligopoly, or monopolistically competitive firm, the marginal revenue curve is negatively sloped and lies below the average revenue (demand) curve.

Marginal Revenue Curve, Monopolistic Competition

The vertical axis measures marginal revenue and the horizontal axis measures the quantity of output (number of sandwiches). Although quantity on this particular graph stops at 10 sandwiches, it could go higher.

This exhibit displays both the marginal revenue curve (MR) and the average revenue curve (AR), which is also the demand curve. Both are negatively sloped, but the marginal revenue curve lies below the average revenue curve, which means that marginal revenue is less than average revenue (and price) for any given quantity.

How can this be? Why is this so? An explanation seems in order.

Consider the situation facing Manny Mustard. If Manny sets his sandwich price at $5.05, then buyers are willing to purchase 4 sandwiches. However, if Manny wants to increase the quantity sold from 4 sandwiches to 5, then he MUST lower the price from $5.05 to $5 per sandwich. But here is the catch: Manny must lower the price for ALL, not just the extra sandwich.

What happens to Manny's total revenue when he lowers the price? Two forces are at work: (1) the revenue gained by adding extra sandwiches and (2) the revenue lost by lowering the price for existing sandwiches. Marginal revenue is the net result of both.

• First, by lowering his price, Manny increases the quantity sold from 4 to 5 sandwiches. This extra sandwich generates an extra $5 of revenue, the price of the fifth sandwich. This is $5 of extra revenue that Manny did NOT have at the higher price. If this is all that happens, then Manny has a marginal revenue of $5 for selling the fifth sandwich, equal to the price.

• Second, by lowering his price, Manny collects less revenue from his other 4 sandwiches. He would have collected $5.05 per ounce for a total of $20.20. But with the lower $5 price he collects only $20, a reduction of total revenue by $0.20, or $0.05 per sandwich.

Although this marginal revenue curve is based on the production activity of Manny Mustard, a monopolistically competitive firm, it applies to any firm with market control. Monopoly and oligopoly firms that also face negatively-sloped demand curves generate comparable marginal revenue curves.