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Price Elasticity of Demand and Total Revenue

• Levels: AS, A Level
• Exam boards: AQA, Edexcel, OCR, IB, Other, Pre-U

The relationship between elasticity of demand and a firm's total revenue is an important one.

• When demand is inelastic – a rise in price leads to a rise in total revenue – a 20% rise in price might cause demand to contract by only 5% (Ped = -0.25)
• When demand is elastic – a fall in price leads to a rise in total revenue - for example a 10% fall in price might cause demand to expand by only 25% (Ped = +2.5)
• When demand is perfectly inelastic (i.e. Ped = zero), a given price change will result in the same revenue change, e.g. a 5 % increase in a firm's prices results in a 5 % increase in its total revenue

The table below gives an example of the relationships between prices; quantity demanded and total revenue. As price falls, the total revenue initially increases, in our example the maximum revenue occurs at a price of £12 per unit when 520 units are sold giving total revenue of £6240.

 Price Quantity Total Revenue Marginal Revenue £ per unit Units £s £s 20 200 4000 18 280 5040 13 16 360 5760 9 14 440 6160 5 12 520 6240 1 10 600 6000 -3 8 680 5440 -7 6 760 4560 -11
• Consider the elasticity of demand of a price change from £20 per unit to £18 per unit. The % change in demand is 40% following a 10% change in price – giving an elasticity of demand of -4 (i.e. highly elastic).
• In this situation when demand is price elastic, a fall in price leads to higher total consumer spending / producer revenue
• Consider a price change further down the estimated demand curve – from £10 per unit to £8 per unit. The % change in demand = 13.3% following a 20% fall in price – giving a co-efficient of elasticity of – 0.665 (i.e. inelastic). A fall in price when demand is price inelastic leads to a reduction in total revenue.
 Change in the market What happens to total revenue? Ped is inelastic (<1) and a firm raises its price. Total revenue increases Ped is elastic (>1) and a firm lowers its price. Total revenue increases Ped is elastic (>1) and a firm raises price Total revenue decreases Ped is unit elastic (=1) and a firm raises price Total revenue remains the same Ped is -1.5 (elastic) and the firm raises price by 4% Total revenue decreases Ped is -0.4 (inelastic) and the firm raises price by 30% Total revenue increases Ped is -0.2 (inelastic) and the firm lowers price by 20% Total revenue decreases Ped is -4.0 (elastic) and the firm lowers price by 15% Total revenue increases

The Usefulness of Price Elasticity of Demand for Producers

Firms can use PED estimates to predict:

• The effect of a change in price on total revenue of sellers
• The price volatility in a market following changes in supply – this is important for commodity producers who suffer big price and revenue shifts from one time period to another.
• The effect of a change in an indirect tax on price and quantity demanded and also whether the business is able to pass on some or all of the tax onto the consumer.
• Information on the PED can be used by a business for price discrimination. This is where a supplier decides to charge different prices for the same product to different segments of the market e.g. peak and off peak rail travel or prices charged by many of our domestic and international airlines.
• Usually a business will charge a higher price to consumers whose demand for the product is price inelastic

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