Question

explain the relationship between the proce elasticity of demand and total revenue. what are the impacts of various forms of elasticities (elastic, inelastic, unit elastic, etc.) on business decisions and atrategies to maximaize profit? explain your reaponses using empirical examples, formulas and graphs.

Answer 1

As we know the price elasticity of demand and total revenue is positively related. But price elasticity of demand (suppose E_p) can be of three types such as elastic (when E_p>1), inelastic (when E_p<1)and unitary (when E_p=1). For instance, if total reve­nue increases as price increases then the price elasticity of demand is said to be elastic (i.e. E_p>1). On the contrary, if total reve­nue decreases as price decreases then the price elasticity of demand is said to be inelastic (i.e. E_p<1). But if total reve­nue remains constant whether price increases or decreases then price elasticity of de­mand is said to be unitary (i.e. E_p=1).

This can be explained with the following diagram.

(i) When E_p > 1, i.e., demand is elastic, TR in­creases as P rises and MR is positive.

(ii) When E_p = 1, i.e., demand is unitary elastic, TR is constant as P falls, and MR is zero.

(iii) When E_p < 1, i.e., demand is inelastic, TR falls as P falls, and MR < 0.

Here, TR=Total Revenue, P=Price, MR=Marginal Revenue.

So if the demand for a firm’s product is inelastic (i.e., E_p < 1) one should not reduce price to raise revenue. Rather the only way of raising revenue is to raise price. But if demand is elastic (i.e., E_p > 1) per­centage expansion of quantity exceeds percentage contraction of price. So TR rises as P falls. However, it may be noted that even if demand is elastic a firm may not gain by reducing price and increasing quantity. In fact, increase in output and sales implies an increase in both revenue and cost of production. The business manager’s price and output decisions do depend on comparison of MR with mar­ginal cost (i.e., the extra cost of producing an addi­tional unit). If demand is unitary (i.e., E_p = 1), there is no scope for raising TR either by reducing P or by raising it. So the only way of raising TR is to reduce cost of production per unit of output (by raising or reducing the volume of output).