A city has built a bridge over a river and it decides to charge a toll...

A city has built a bridge over a river and it decides to charge a toll to everyone who crosses. For one year, the city charges a variety of different tolls and records information on how many drivers cross the bridge. The city thus gathers information about elasticity of demand. If the city wishes to raise as much revenue as possible from the tolls, where will the city decide to charge a toll: in the inelastic portion of the demand curve, the elastic portion of the demand curve, or the unit elastic portion? Explain using elasticity and total revenue diagram

Expert Solution

The relationship between elasticity and total revenue is as follows:

if demand is inelastic, and increase in price will lead to an increase in total revenues
if demand is elastic, an increase in price will lead to a decrease in total revenues

When demand is inelastic, it implies that consumers don't have a lot of options and would be willing to pay the higher prices.

If demand is elastic, consumers will have other substitutes or options, and they will not pay the toll.

Hence, the city should charge a toll in the inelastic portion of the demand curve.

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This is shown in the diagram as follows:

When the toll is low, quantity of cars is Q₁. When the toll is high, quantity is Q₂.

The percentage change in quantity is very small, but the percentage change in price (toll) is much higher.

Total Revenue is given by area of the rectangle P x Q.

It can be observed that:

Area of rectangle OP₂BQ₂is greater than Area of rectangle OP₁BQ₁

Thus, a higher toll has resulted into a higher total revenue. This is only because demand is inelastic in the diagram.

Rahul Sunny answered 2 years ago

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