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Elasticity and Total Revenue

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43 views2 pages

Elasticity and Total Revenue

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armaandube11
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BOSTON COLLEGE

Department of Economics

ECON 1101 Prof. Konan


Principles of Economics

Elasticity and Total Revenue

1. Price Elasticity of Demand and Total Revenue

▪ Price elasticity of demand can be defined or inferred in terms of changes in total


revenue.
▪ Total revenue is measured by:

𝑇𝑅 = 𝑃 × 𝑄

▪ Price (P) and quantity (Q) move in opposite directions along a downward sloping
demand curve. As the price increases, other things equal, quantity demanded
decreases; conversely, as the price decreases, other things equal, quantity
demanded increases.
▪ Total revenue changes in the direction of the dominant effect between the price
effect and the quantity effect.
▪ If the price effect on total revenue dominates, then total revenue changes in the
same direction as price, and demand is inelastic between the prices.
▪ If the quantity effect on total revenue dominates, then total revenue changes in
the same direction as quantity, and demand is elastic between the prices.
▪ If neither effect on total revenue dominates, then total revenue remains
unchanged, and demand is unit elastic between the prices.
▪ For example, suppose that the price increases and quantity demanded decreases:
▪ If total revenue increases, it must be that the price effect on total revenue
dominates, and demand is inelastic between the prices.
▪ If total revenue decreases it must be that the quantity effect on total revenue
dominates, and demand is elastic between the prices.
▪ If total revenue remains unchanged, it must be that neither effect on total
revenue dominates, and demand is unit elastic between the prices.
▪ Conversely, suppose that the price decreases and quantity demanded increases:
▪ If total revenue decreases, it must be that the price effect on total revenue
dominates, and demand is inelastic between the prices.
▪ If total revenue increases it must be that the quantity effect on total revenue
dominates, and demand is elastic between the prices.
▪ If total revenue remains unchanged, it must be that neither effect on total
revenue dominates, and demand is unit elastic between the prices.
▪ Example: Consider a straight-line demand curve which goes through the points (p=12,
q=2200) and (p=10, q=2400). Compute the elasticity of demand.
ANSWER:

Using the elasticity formula:

∆𝑸𝒅 /𝑸𝒅 (𝟐𝟒𝟎𝟎 − 𝟐𝟐𝟎𝟎)/𝟐𝟑𝟎𝟎 𝟐𝟎𝟎/𝟐𝟑𝟎𝟎 𝟐 𝟏𝟏 𝟏𝟏


𝑬𝑫 = | |=| |= = × = ≅ 𝟎. 𝟒𝟕𝟖𝟑 < 𝟏
∆𝑷/𝑷 (𝟏𝟎 − 𝟏𝟐)/𝟏𝟏 𝟐/𝟏𝟏 𝟐𝟑 𝟐 𝟐𝟑

Demand is inelastic between $10 and $12.

Using the changes in total revenue approach:

𝑻𝑹𝟏 = 𝟏𝟐 × 𝟐𝟐𝟎𝟎 = 𝟐𝟔𝟒𝟎𝟎


𝑻𝑹𝟐 = 𝟏𝟎 × 𝟐𝟒𝟎𝟎 = 𝟐𝟒𝟎𝟎𝟎

As the price falls (from $12 to $10) and quantity rises (from 2200 to 2400), total
revenue falls (from 26400 to 24000). Total revenue follows price (total revenue
moves in the same direction as price). It must be that the price effect on total
revenue dominates. Therefore, demand is inelastic between $10 and $12.

2. Price Elasticity of Supply and Total Revenue

▪ Price elasticity of supply cannot be defined or inferred in terms of changes in total


revenue.
▪ This is because price and quantity move in the same direction along an upward sloping
supply curve.
▪ Total revenue must necessarily move in the same direction as both price and quantity,
regardless of price elasticity of supply.

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