Question

If the elasticity of demand is -1.5 and there is a 10% price increase, do total revenues increase or decrease?

Explain how you arrived at your answer. By what percentage do the revenues change?

Answer 1

Answer: decrease

The price elasticity of demand (PED) is -1.5 here; therefore, PED > 1; this indicates that the product is price elastic. In case of price elastic if price is increased, total revenue falls.

PED = % change in quantity demanded / % change in price

-1.5 = % change in quantity demanded / 10%

% change in quantity demanded = -1.5 × 10%

                                                     = -15%

Therefore, if price increases by 10% the quantity demanded will drop by 15%.

Change in revenue:

Suppose the earlier price is $10 and earlier quantity is 100 units.

Therefore, total revenue (TR) = Price × Quantity

                                                = $10 × 100

                                                = $1,000

Now, price increases by 10% and quantity decreases by 15%.

New price = $10 × (1 + 0.10)

                 = $10 × 1.10

                 = $11

New quantity = 100 × (1 – 0.15)

                        = 100 × 0.85

                        = 85

New TR = New price × New quantity

               = $11 × 85

                = 935

Therefore, TR decreases by (1,000 – 935 =) $65

Revenues decreases by = (Decrease in TR / Earlier TR) × 100

                                       = ($65 / $1,000) × 100

                                       = 6.5% (Answer)