Price Elasticity of Demand and Total Revenue

Price elasticity of demand (PED) measures how responsive the quantity demanded of a good or service is to a change in its price. Total revenue (TR) is the total amount of money earned by selling a certain quantity, calculated as TR = Price (P) x Quantity (Q). Here’s how they connect:

• Elastic Demand (PED > 1): A small price increase leads to a larger percentage decrease in quantity demanded. This means total revenue might decrease even though the price goes up. Imagine a luxury good like high-end headphones. A price hike might make many people switch to cheaper brands, reducing total revenue.

Formula: % Change in Quantity Demanded > % Change in Price

Graph: A downward-sloping demand curve with a flatter slope compared to an inelastic demand curve.

• Inelastic Demand (PED < 1): A small price increase leads to a smaller percentage decrease in quantity demanded, or even an increase. Total revenue is likely to increase despite the price rise. This applies to necessities like insulin. People might cut back on other expenses but still need insulin, so total revenue could rise.

Formula: % Change in Quantity Demanded < % Change in Price

Graph: A downward-sloping demand curve with a steeper slope compared to an elastic demand curve.

• Unit Elastic Demand (PED = 1): A small price increase leads to an equal percentage decrease in quantity demanded. Total revenue remains roughly the same. This is rare but could apply to some staple goods with readily available substitutes.

Formula: % Change in Quantity Demanded = % Change in Price

Graph: A downward-sloping demand curve with a slope between elastic and inelastic curves.

Business Decisions and Strategies:

• Elastic Demand: Businesses might lower prices to sell more units and potentially increase total revenue. They might also focus on product differentiation or brand loyalty to make their product less price-sensitive.
• Inelastic Demand: Businesses can raise prices to increase total revenue, but they should consider how much consumers are willing to pay before demand drops significantly.
• Unit Elastic Demand: Businesses should focus on cost efficiency to maximize profits, as price changes won’t significantly impact total revenue.

Elasticity in the Short vs. Long Run

Price elasticity of demand is generally more elastic in the long run than in the short run. This means a price change will have a larger impact on quantity demanded in the long run. Here’s why:

• Short Run: Consumers might have limited substitutes readily available, making them less responsive to price changes. Imagine a sudden gas price increase. People might not be able to buy a new car immediately, so demand stays relatively stable.
• Long Run: Consumers have more time to adjust. They might find substitutes, change consumption patterns, or switch brands. With the gas price example, in the long run, people might buy a more fuel-efficient car or use public transportation, making demand more elastic.

Government and Market Imperfections

Government policies (taxes, subsidies) and market imperfections (monopolies, externalities) can affect price elasticity:

• Taxes: Taxes generally decrease demand (make it more price elastic) as the effective price for consumers increases.
• Subsidies: Subsidies can make demand more inelastic as the good becomes cheaper for consumers.
• Monopolies: Monopolies can restrict supply, making it less elastic and potentially allowing them to charge higher prices.
• Externalities: Negative externalities (pollution) might make demand more elastic as consumers become more aware of the drawbacks.

Understanding these relationships helps businesses make informed pricing decisions, and policymakers design effective economic interventions.