Question

Topic 1: Price elasticity of demand is an important concept. With appropriate examples, explain how this concept is related to total revenue. (Hint: When providing example, select a product whose demand may be relatively elastic; therefore, lowering its price may lead to increase in total revenue. This will allow other students to choose a different example.)

(Please post answer in written form and not chart form)

Answer 1

Price elasticity of demand (Ed) measures the responsiveness of quantity demanded of a good to its price. The higher (lower) the responsiveness, the more elastic (inelastic) demand for the good is. Ed is measured as the ratio of percentage change in quantity demanded to the percentage change in price, expressed as

Ed = % Change in Qd / % Change in P

When demand is elastic (inelastic), a N% change in price causes a higher than (less than) N% change in quantity demanded, therefore absolute value of Ed is higher than (lower than) 1. Therefore, total revenue increases (decreases) when price falls (rises), and total revenue decreases (increases) when price rises (falls) with elastic (inelastic) demand.

For example, consider ice-cream as a good, whose demand is relative elastic. If price of ice-cream falls (rises), its quantity demanded rises (falls) more than (less than) proportionately, therefore total revenue rises (falls). On the other hand, if its price rises (falls), its quantity demanded falls (rises) more than (less than) proportionately, therefore total revenue falls (rises). So the appropriate pricing strategy is to lower prices when demand for the good is elastic, and raise prices when demand for the good is inelastic.