Understanding the Relationship Between Total Revenue and ...

Understanding the Relationship Between Total Revenue and Elasticity

Review: Total revenue is price times quantity demanded: TR = P x Q.

Review: Elastic demand indicates price sensitivity; inelastic demand indicates price

insensitivity.

When price changes, you can analyze the change in total revenue in terms of a price

effect and a quantity effect. Elasticity determines which effect is greater after a change

in price.

Begin this section by reviewing the formula for

total revenue: TR = P x Q.

The box on the left summarizes the

relationship between price changes, total

revenue, and elasticity:

1. With products that are price-sensitive, or

elastic, a percentage change in price means a

greater percentage change in quantity

demanded. Total revenue and price move

in opposite directions.

2. With products that are price-insensitive, or

inelastic, a percentage change in price

means a smaller percentage change in

quantity demanded. Total revenue and

price move in the same direction.

Using math shows that the relationships on

the left are true.

The mathematical relationship above is

analogous to the formula for finding a change

in total revenue when the price changes.

The formula in the lower part of the box on

the left says that the percentage change in

total revenue is equal to the percentage

change in price + the percentage change

in quantity demanded.

Assume that the change in price is an

increase. A price increase means that there

will be a decrease in quantity because the

demand curve is downward sloping.

By manipulating the equation, you can see

that the last term on the right is the formula

for elasticity.

If the elasticity is less than 1, as it is here,

then the product has inelastic demand.

The price effect is the increase in revenue

from selling the product at a higher price.

The quantity effect is the decrease in

revenue from the fall in quantity demanded

caused by the increase in price.

In this case, the price effect has dominated.

The increase in price has not caused a large

loss of customers. There has not been a large

decrease in quantity demanded, or a large

quantity effect. Therefore the increase in

total revenue from the price effect is greater

than the decrease in total revenue from the

quantity effect.

To summarize:

If the quantity effect dominates, then elasticity

is greater than 1 (demand is elastic), and

total revenue and price move in opposite

directions.

If the price effect dominates then elasticity is

less than 1 (demand is inelastic), and total

revenue and price move in the same

direction.

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