Lecture Notes: Price Elasticity of Demand and Total Revenue
Key Concepts
Total Revenue (TR)
- Formula: TR = P * Q
- P: Price of a good/service
- Q: Quantity sold
- Businesses use this formula to make pricing decisions.*
Price Elasticity of Demand (PED)
- Price Elastic Demand:
- If price changes, total revenue (TR) moves in the opposite direction.
- Increase price → Decrease TR
- Higher prices cause a significant drop in quantity demanded.
- Decrease price → Increase TR
- Lower prices cause a substantial rise in quantity demanded.
- Price Inelastic Demand:
- If price changes, TR moves in the same direction.
- Increase price → Increase TR
- Higher prices cause a minor drop in quantity demanded.
- Decrease price → Decrease TR
- Lower prices cause a slight increase in quantity demanded.
Illustrative Examples
Price Elastic Demand Example
- Scenario: Decreasing price
- Initial Revenue: P1Q1 = P1AQ10
- New Revenue: P2Q2 = P2BQ20
- Revenue Analysis:
- Revenue Gained: Green box
- Revenue Lost: Red box
- Outcome: Green box (gained) > Red box (lost)
- Conclusion: Lowering price when demand is elastic increases total revenue.
Price Inelastic Demand Example
- Scenario: Increasing price
- Initial Revenue: P1Q1 = P1AQ10
- New Revenue: P2Q2 = P2BQ20
- Revenue Analysis:
- Revenue Gained: Large green box
- Revenue Lost: Small red box
- Outcome: Green box (gained) > Red box (lost)
- Conclusion: Increasing price when demand is inelastic increases total revenue.
Important Reminders
- Elasticity mnemonic: "Elastic only irritates skin."
- Elastic demand: Opposite reaction
- Inelastic demand: Same reaction
Conclusion
- Understanding PED is crucial for pricing strategies aimed at maximizing total revenue.
- Elastic Demand: Lower price to increase TR.
- Inelastic Demand: Raise price to increase TR.
- Analyze diagrams to visualize and confirm these strategies.
Note: This relationship between PED and TR is fundamental in economics and provides strategic insights for businesses on pricing decisions.