Price Elasticity of Demand and Total Revenue
The price elasticity of demand affects the total revenue a market can generate when prices change. When demand is inelastic, price and total revenue move in the same direction—if the price increases, revenue also increases. However, when demand is elastic, price and total revenue move in opposite directions—if the price increases, total revenue decreases. When demand has unitary elasticity, total revenue remains constant despite price changes. Let’s explore why.
Total Revenue and Inelastic Demand
Total revenue is calculated as price multiplied by quantity, and in the graph, the area of a rectangle represents this product. Initially, when the price is 30 and the quantity demanded is 400, total revenue is 12,000 (the sum of the blue and red areas). This is because the base of the rectangle is 400 and the height is 30, resulting in an area of 12,000.
If the price rises from 30 to 60, the quantity demanded decreases to 250, and total revenue increases to 15,000 (the sum of the blue and green areas). With a price increase, sellers lose the red area (400 - 250) 30 = 4,500, but gain the green area of 250 (60 - 30) = 7,500.
Since the demand is inelastic, the quantity demanded decreases by a smaller proportion than the price increase. As a result, sellers sell fewer units, but each unit is sold at a higher price, compensating for and exceeding the lost revenue, leading to an overall increase in total revenue.
Total Revenue and Elastic Demand
In contrast, when demand is elastic, price increases lead to a reduction in total revenue. In the graph, when the price is 30, total revenue is 700 * 30 = 21,000 (the sum of the blue and red areas).
If the price rises to 50, the quantity demanded decreases to 300, leaving total revenue at 300 * 50 = 15,000. In this case, total revenue decreases because the demand is elastic, meaning the reduction in quantity demanded is proportionally greater than the price increase. Therefore, even though sellers are charging a higher price per unit, they are not selling enough units to maintain or surpass previous total revenue levels.
In the graph, total revenue falls by the red area (700 - 300) 30 = 12,000 and increases by the green area of 400 (50 - 30) = 8,000.
Conclusion: Relationship Between Elasticity and Total Revenue
Elasticity measures how sensitive the quantity demanded is to price changes. When demand is elastic, consumers respond to price increases by reducing their consumption, either by substituting the product or ceasing to consume it altogether. In contrast, inelastic demand indicates that consumers have limited ability to respond to price changes, often because the good lacks close substitutes or is a necessity. Therefore, understanding elasticity helps predict how changes in price will impact total revenue.