Hi everybody. Price elasticity of demand is crucial for businesses when making pricing decisions to increase their total revenue. Total revenue has got this equation.
It's P times Q, the price of a good or service, multiplied by the quantity sold. So if a business knows that demand... band for that good is price elastic or price inelastic, what should they do with price to increase their total revenue?
In your head, just remember, elastic only irritates skin. And it's true. If you put an elastic band on your arm or on your skin, rub it around, it's very irritating. So just remember, elastic only irritates skin. Elastic, opposite, inelastic, same.
That's the relationship between PED, price changes, and TR. Let's understand that with some examples. So let's say a business knows that demand for their good is price elastic.
Whatever they do with price, the opposite will happen with total revenue. Okay? Let's understand why. So demand is price elastic. If the price goes up, total revenue is going to fall.
And that's because they increase their price, quantity of demand is going to drop off. significantly. So you're selling a lot less at a slightly higher price, total revenue is going to fall. Whereas if demand is price elastic and you reduce your price, quantity demand is going to increase massively.
So you're selling loads more at a slightly reduced price, total revenue is going to massively increase. Whereas if demand is price inelastic, whatever you do with price as a business, the same is going to happen with TR. So if you raise your price, TR is going to increase.
So if you increase your price, quantity demand will fall, yeah, but only by a little bit. So you're selling a little bit. bit less but at a much higher price, that's going to increase TR.
Whereas if demand is price inelastic and you drop your price, TR is going to fall. It's going to do the same thing. It's going to decrease.
Why is that? Because as you decrease your price, yeah, quantity demand will increase but only by a tiny bit. So you're selling only a little bit more but at a much lower price. Total revenue is going to fall. We can actually prove these concepts on diagrams.
Let's take this top diagram first here. You can clearly see that demand is price inelastic because it's a shallow curve. So as we decrease the decrease the price here, you can see that quantity demanded increases proportionally more than the decrease in price. We get to Q2. If we look at the initial revenue, the initial revenue is P times Q, P1 times Q1.
That gives us P1AQ10. That's P1AQ10. But the new revenue is now P2 times Q2. That's P2BQ20.
So P2BQ20. The way to prove that revenue has gone up is if we look at revenue gain. and revenue lost.
So it's very clear to see that the revenue gained compared to before is now this green box, whereas the revenue lost is only this little red box. So if we label that the revenue lost, whereas this green box is clearly the revenue gained, it's very clear to see that the green box is much greater than the red box. This box here has remained.
The red has been lost, the green has been The revenue gained is much greater than the revenue lost. So this pricing decision of reducing price when demand is price-elastic is clearly in the interest of producers when they want to increase their total revenue. We'll prove it when demand is price-inelastic as well. So we've said that when demand is price-inelastic, the price should be increased by a business to increase their total revenue.
Let's understand again. So if we see here, I'll label that A and label that B. At price P1, quantity Q.
Q1 is being sold, so initial revenue is P1 times Q1, which gives P1A, Q1, 0. Whereas when the price is raised, the new revenue is P2 times Q2, that's P2B, Q2, 0. And we'll do exactly the same thing. If we look at the revenue lost, it's this little bit down here, so we'll label that the revenue lost. And if we look at the revenue gained, it's this massive green box here. That's it.
That's the revenue gained. And again, it's very clear to see that the revenue gained significantly outweighs the revenue lost. And it shows that when demand is price elastic, raise price to increase total revenue. When demand is price elastic, reduce price to increase total revenue.
So hopefully that now makes sense. A very important relationship in economics. Thank you so much for watching, guys. I'll see you in the next video.