Economics Online Tutor
The importance of the price elasticity of demand for a business can be shown
by the effect that it has on total revenue. The business will want to know
whether a proposed price change will increase or decrease total revenue.
Total revenue, by definition, is equal to the price times the quantity sold
(TR=PxQ). [sometimes, when dealing with elasticity, the language used may
call this total expenditures instead of total revenue, but it has the same
Note what happens to the results of this formula (TR=PxQ) if a price change is
involved. Due to the law of demand, the price will move in one direction, and
the quantity sold will move in the other direction. Unless the price change and
quantity change are both for the same percentage (unit elastic), then total
revenue will also change whenever a price change is involved. The question
is, does total revenue increase, or decrease? The answer depends on the
direction of the price change along with the price elasticity of demand.
If the price elasticity of demand is elastic (greater than 1), then that means that
the quantity change is more than the price change. So total revenue (price
times quantity) will decrease for a price increase, and increase for a price
If the price elasticity of demand is inelastic (less than 1), then that means that
the quantity change is less than the price change. So total revenue (price
times quantity), increases for a price increase, and decreases for a price
Elastic demand, price increase: total revenue decreases
Elastic demand, price decrease: total revenue increases
Inelastic demand, price increase: total revenue increases
Inelastic demand, price decrease: total revenue decreases
Unit elastic demand: total revenue does not change
So, you can see from this, that the price elasticity is an important element in
the pricing decisions of businesses.
One more thing about the relationship between the price elasticity of demand
and total revenue: As long as demand is either elastic or inelastic, total
revenue can always be increased with a price change in the proper direction.
The only point where total revenue is maximized is the point where the price
elasticity of demand is unit elastic.
|The Relationship Between the Price
Elasticity of Demand and Total
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