Price Elasticity of Demand and Total Revenue

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Learning Contents:                                                            

·         Concept of Price Elasticity of Demand and Total revenue

·         Relationship between  Price Elasticity and Total revenue

·         Impact of Price change on the Total revenue of the Firm

 

Price Elasticity of Demand

Price elasticity of demand explains how much change can be seen in quantity demanded as a result of change in the price of the commodity. It shows whether the demand for the commodity is elastic i.e. very responsive to price change or inelastic i.e. less responsive to price change. When an increase in price reduces the quantity demanded a lot and decrease in price increases the quantity demanded a lot is called elastic demand. On the other hand, when an increase in price reduces the quantity demanded just a little and decrease in price increases the quantity demanded just a little is called an inelastic demand.

 

Total Revenue:

The amount of money that a firm receives from the sale of its total output is called total revenue. It is calculated by multiplying the price by quantity demanded or sold.  For example, a firm sells 100 units of cookies at a price of ₹ 10 each, the total revenue of the firm will be:

TR= Price × Quantity Demanded/ Sold

TR= 10× 100 = ₹ 1000

An important point to note here is that the total revenue includes cost and profits. Continuing the above example, if a firm incurs a cost of ₹ 200 in producing the cookies and earns a profit of ₹ 800. Therefore, the total revenue will be:

Total Revenue = Profits + Costs                                        (Because, Profit = Total Revenue – Costs)

₹1000= ₹800 + ₹200


Relationship between Price Elasticity and Total Revenue

The total revenue of the firm can be determined on the basis of the price and elasticity of a good. Goods with inelastic demand are priced high to earn high revenue. On the other hand, goods with elastic demand are priced lower to earn high revenue. Therefore, the total revenue of the firm changes on the basis of the price charged and the elasticity of the good. The effect of price change on quantity demanded and on the total revenue of the firm is explained as below:














Diagram 1: Price Elasticity of Demand and Total Revenue.

 


















Impact of Price change on the total revenue of the firm

The effect of change in price on the total revenue of the seller can be understood with the help of following three situations explained below:

1. When Demand is Elastic

Demand is said to be price elastic when Ed > 1 i.e. Demand is highly responsive to the price change. Simply, when the percentage change in quantity demanded > percentage change in price. A rise in price leads to a larger fall in quantity demanded and therefore, decreases the total revenue of the seller. On the other hand, a fall in price leads to a larger increase in quantity demanded and therefore, increases the total revenue of the seller.





Elastic Demand and Total Revenue Example:

The Table 1 and Figure 1 explains the effect of price change on the total revenue when the price of soda drink falls from ₹ 8 to ₹ 6 and quantity demanded increases from 5 units to 15 units.

                 Table 1

P=8

Q=5

TR before price falls i.e. ₹40

P1 =6

Q1 =15

TR after price falls i.e. ₹90









    Figure 1












In Figure 1, DD is the demand curve having a flatter slope that shows an elastic demand i.e. change in quantity demand is more than the change in price. The red shaded area shows an increase in total revenue as quantity demanded increased from 5 units to 15 units and the green shaded area shows a decrease in total revenue on account of fall in price from ₹ 8 to ₹ 6. It shows that increase in quantity demand is more than fall in price.

2. When Demand is inelastic:

Demand is said to be price inelastic when Ed < 1 i.e. Demand is less responsive to the price change. Simply, when the percentage change in quantity demanded < percentage change in price. A rise in price leads to a smaller fall in quantity demanded and therefore, increases the total revenue of the seller. On the other hand, a fall in price leads to a smaller increase in quantity demanded and therefore, decreases the total revenue of the seller.





Table 2

P=4

Q=15

TR before price rise i.e. ₹60

P1 =8

Q1 =10

TR after price rise i.e. ₹80








Figure 2













In Figure 2, DD is the demand curve having a steep slope that shows an inelastic demand i.e. change in quantity demand is less than the change in price. The red shaded area shows an increase in total revenue on account of price rises from ₹ 4 to ₹ 8 and the green shaded area shows a decrease in total revenue on account of fall in quantity demanded from 15 units to 10 units. It shows that the change in quantity demand is less than the change in price.


3. When Demand is Unitary Elastic:

Demand is said to be unitary elastic when Ed = 1 i.e. Demand is equally responsive to the price change. Simply, when the percentage change in quantity demanded = percentage change in price. When an increase in price exactly balances the reduction in quantity demanded respectively keeping total revenue unchanged. In this case, price change has no effect on the total revenue of the seller i.e. remains unchanged. 





Figure 3



















            Summary  of the Relationship of Price, Elasticity, and Total revenue:

 

 

Increase in Price

 

Decrease in Price

When Demand is Elastic

 

Revenue Falls

 

Revenue Rises

When Demand is Inelastic

 

Revenue Rises

 

Revenue Falls

When Demand is Unitary Elastic

 

Revenue Same

 

Revenue Same

Let’s try some questions

Choose the Correct Answer

1. When price falls and demand is inelastic, total revenue?

a. Decreases

b. Increases

c. Constant

d. None of above.

2. When price rises and demand is elastic, total revenue?

a. Decreases

b. Increases

c. Constant

d. None of above.

3. When price falls and demand is elastic, total revenue?

a. Decreases

b. Increases

c. Constant

d. None of above.

4. When price rises and demand is inelastic, total revenue?

a. Decreases

b. Increases

c. Constant

d. None of above.

5. When price rises and demand is unitary elastic, total revenue?

a. Decreases

b. Increases

c. Constant

d. None of above.

6. The elasticity of demand for a good is 0.1. If the producer raises prices by 10%, what will happen to his total revenue?

a. It will decrease

b. It will increase

c. It will remain constant

d. None of above.

7. A manager of a restaurant wants to increase his revenue.  The servers suggest for decreasing the price of food and drinks. The server’s recommendation is based on the assumption that

a. Demand for food and drink is elastic

b. Demand for food and drink is inelastic

c. Demand for food and drink is unitary elastic

d. None of above.

8. If demand is inelastic,.................... in price leads to ......................... in total revenue.

a. a decrease, an increase.

b. a decrease, a decrease.

c. an increase, a decrease.

d. an increase, an increase.

 

Answer Key

 

1.a

2.a

3.b

7. a

4.b

5.c

6. b

8. d

 

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