Understanding the relationship between price elasticity of demand and total revenue is essential for analyzing how changes in price affect a firm’s earnings.
What is total revenue?
Total revenue (TR) is the total amount of money a firm receives from selling its goods or services in a given time period. It is a fundamental concept in microeconomics because it directly affects business profits and pricing strategies.
Total Revenue = Price × Quantity Sold
Changes in the price of a good typically cause changes in the quantity demanded. However, whether these changes lead to higher or lower total revenue depends on how responsive consumers are to the price change. This responsiveness is captured by the concept of price elasticity of demand (PED).
Price elasticity of demand measures how much the quantity demanded of a good changes in response to a change in its price. The nature of this relationship directly influences whether a price increase or decrease will raise or lower a seller’s total revenue.
The connection between elasticity and total revenue
There is a direct relationship between the price elasticity of demand and how total revenue changes when prices change. To understand this connection, it is important to break demand down into three categories:
Elastic Demand (PED > 1)
Inelastic Demand (PED < 1)
Unit Elastic Demand (PED = 1)
Each category of demand behaves differently when the price of a good or service changes. The direction in which total revenue moves will depend on the elasticity of the good in question.
Elastic demand (PED > 1)
When demand is elastic, consumers are very responsive to changes in price. This means that the percentage change in quantity demanded is greater than the percentage change in price.
If price increases, total revenue decreases
If price decreases, total revenue increases
This happens because a small change in price leads to a relatively larger change in the quantity consumers are willing to buy.
Why this occurs:
Consumers can easily switch to substitutes.
The good may be a luxury rather than a necessity.
The good might take up a large share of a consumer's income.
Example:
Imagine a coffee shop increases the price of a latte from 4 dollars to 5 dollars. As a result, the quantity demanded drops from 100 to 60 lattes.
Original total revenue = 4 × 100 = 400 dollars
New total revenue = 5 × 60 = 300 dollars
Even though the price increased, the quantity demanded fell sharply, leading to lower total revenue. This tells us that the demand is elastic.
Graphical representation:
In a graph, an elastic demand curve appears relatively flat, reflecting how a small change in price leads to a large change in quantity. On such a curve, as you increase the price and move up along the curve, total revenue falls because the drop in quantity is too large to compensate for the higher price.
Inelastic demand (PED < 1)
When demand is inelastic, consumers are not very responsive to changes in price. In this case, the percentage change in quantity demanded is smaller than the percentage change in price.
If price increases, total revenue increases
If price decreases, total revenue decreases
This happens because consumers continue to buy the product even if the price goes up.
Why this occurs:
The good is a necessity, like medication or gasoline.
There are few or no close substitutes.
The good takes up only a small proportion of income.
There is limited time to adjust to the price change.
Example:
A gas station raises the price of a gallon of gasoline from 3 dollars to 3.50 dollars. As a result, the quantity demanded falls only slightly from 100 gallons to 95 gallons.
Original total revenue = 3 × 100 = 300 dollars
New total revenue = 3.50 × 95 = 332.50 dollars
Even though fewer gallons are sold, the higher price more than makes up for the decrease in quantity demanded. Total revenue increases, indicating that demand is inelastic.
Graphical representation:
An inelastic demand curve appears steep. Price changes have little effect on quantity demanded. As price increases, total revenue also increases because consumers do not reduce their purchases by much.
Unit elastic demand (PED = 1)
When demand is unit elastic, the percentage change in quantity demanded is exactly equal to the percentage change in price.
If price increases or decreases, total revenue remains unchanged
This means that the effects of changing price and changing quantity cancel each other out, and total revenue stays the same.
Example:
Suppose a theater raises ticket prices from 50 dollars to 55 dollars, which is a 10 percent increase. As a result, ticket sales drop from 100 to 90 tickets, which is a 10 percent decrease.
Original total revenue = 50 × 100 = 5,000 dollars
New total revenue = 55 × 90 = 4,950 dollars (very close to 5,000 due to rounding)
Because the change in quantity matches the change in price, total revenue does not change. This is the hallmark of unit elasticity.
Graphical representation:
On a linear demand curve, there is a specific point—usually the midpoint—where demand is unit elastic. At this point, total revenue is maximized. Moving in either direction from this point causes total revenue to fall.
The total revenue test
The total revenue test is a simple tool to determine whether demand is elastic, inelastic, or unit elastic based on observed changes in price and total revenue. It is especially useful when actual elasticity values are not available.
If price and total revenue move in opposite directions, demand is elastic.
If price and total revenue move in the same direction, demand is inelastic.
If total revenue remains unchanged, demand is unit elastic.
This test helps students and businesses quickly classify demand behavior without performing complex calculations.
Elasticity and total revenue on a demand curve
The linear demand curve
A linear demand curve has a constant slope, but elasticity changes at different points along the curve. This is a key distinction: slope and elasticity are not the same thing.
Along a straight-line demand curve:
The upper portion is elastic: a price increase leads to a large fall in quantity, reducing total revenue.
The midpoint is unit elastic: total revenue is at its maximum.
The lower portion is inelastic: a price increase leads to a small fall in quantity, increasing total revenue.
As you move down the demand curve:
Price decreases
Quantity increases
Elasticity decreases
Visual example:
If a firm lowers its price and sees a large increase in total revenue, it is likely in the elastic portion of the demand curve. If the same price drop results in only a slight gain in revenue or a decrease, the firm is likely in the inelastic portion.
Real-world examples
Elastic demand – Designer shoes
Suppose a luxury brand drops the price of its designer shoes from 500 dollars to 400 dollars. Because the demand is elastic (luxury goods often are), sales increase significantly from 1,000 pairs to 1,500 pairs.
Old revenue = 500 × 1,000 = 500,000 dollars
New revenue = 400 × 1,500 = 600,000 dollars
The price cut leads to a significant increase in total revenue, showing that demand is elastic.
Inelastic demand – Prescription medication
A pharmaceutical company increases the price of an essential drug from 100 dollars to 120 dollars. Sales fall only slightly, from 10,000 units to 9,800 units.
Old revenue = 100 × 10,000 = 1,000,000 dollars
New revenue = 120 × 9,800 = 1,176,000 dollars
Even with fewer units sold, the price increase results in greater total revenue, indicating inelastic demand.
Unit elastic demand – Fast food combo meals
A fast-food chain experiments with pricing a combo meal at different levels. They find that at 6 dollars, they sell 1,000 meals and make 6,000 dollars in revenue. At 7 dollars, they sell 857 meals and make almost exactly the same total revenue.
6 × 1,000 = 6,000 dollars
7 × 857 = 5,999 dollars
Because total revenue remains constant, this suggests the combo meal is at a unit elastic point.
Business implications of the elasticity-revenue relationship
Understanding how elasticity affects revenue is crucial for businesses when setting prices. Misjudging elasticity can lead to lost revenue or decreased market share.
If demand is elastic, lowering prices can lead to a large increase in quantity sold and higher total revenue.
If demand is inelastic, raising prices can increase revenue even if fewer units are sold.
If demand is unit elastic, businesses may need to focus on non-price factors like quality, branding, or advertising to improve revenue, since price changes will not help.
Businesses also need to monitor market conditions, as elasticity can change over time. For instance, the development of new substitutes or changes in consumer preferences can make a good more elastic.
Government and taxation
While a full discussion of tax incidence is found in later notes, elasticity is important in determining how taxes affect total revenue and who bears the burden.
If demand is inelastic, the government can raise more revenue from taxes because consumers do not significantly reduce their purchases.
If demand is elastic, a tax may cause a sharp fall in quantity demanded, reducing both consumer spending and government revenue.
FAQ
Yes, the price elasticity of demand for a product can change over time due to shifts in consumer preferences, availability of substitutes, income levels, and the market learning curve. Initially, demand may be inelastic if consumers are unfamiliar with alternatives or if a product is seen as essential. Over time, as consumers become more informed or competitors enter the market, the same product may become more elastic. This shift significantly affects pricing and total revenue strategies. For example, a firm that raises prices when demand is inelastic may later find that the same price hike reduces total revenue if demand becomes elastic. Additionally, technological changes or policy shifts can alter elasticity by introducing new consumption habits. Firms must continuously evaluate elasticity by analyzing consumer behavior and market trends. Basing pricing decisions on outdated elasticity assumptions may result in overpricing or missed opportunities for revenue growth.
Firms can estimate demand elasticity through observation, market testing, and analyzing sales data trends. One practical method is to conduct small-scale price changes and monitor the corresponding change in total revenue. If a price increase leads to higher total revenue, the demand is likely inelastic. If revenue falls, demand is elastic. Firms can also survey customers or observe competitor behavior. For instance, if a competing brand lowers prices and experiences a major increase in sales, it suggests elastic demand in that product category. Additionally, the nature of the product provides hints: essential goods with few substitutes usually have inelastic demand, while luxury goods or items with many alternatives are more elastic. Firms may also analyze purchase frequency, consumer loyalty, and market demographics to make informed estimates. While not exact, these methods help businesses make strategic pricing decisions without relying solely on mathematical elasticity calculations.
No, total revenue does not always increase just because more units are sold. What matters is the price at which those additional units are sold and the elasticity of demand at that price point. If a firm lowers its price to sell more units, and demand is elastic, total revenue will rise because the increase in quantity sold outweighs the price drop. However, if demand is inelastic, selling more units at a lower price might actually reduce total revenue, as the price drop results in insufficient additional sales to make up for the lower revenue per unit. Additionally, in the case of unit elastic demand, total revenue remains unchanged regardless of how many more units are sold. This is why understanding the elasticity of demand at various price levels is critical for firms. Simply increasing sales volume without analyzing elasticity may lead to misjudgments about revenue outcomes.
The shape of a demand curve provides insight into how sensitive quantity demanded is to price changes and, therefore, how total revenue behaves along different segments of the curve. A steep (inelastic) demand curve means that large price changes result in small changes in quantity demanded. In this case, total revenue tends to increase when prices rise. A flatter (elastic) demand curve shows that small price changes lead to large changes in quantity demanded, and total revenue decreases when prices rise. On a linear demand curve, the elasticity varies at different points: the upper part is elastic, the midpoint is unit elastic (where total revenue is maximized), and the lower part is inelastic. This variation means that the effect of a price change on total revenue depends not only on whether price goes up or down, but also on where on the demand curve the firm is operating. Understanding the curve's shape helps businesses predict revenue more accurately.
Consumer perception plays a significant role in determining the elasticity of demand, which in turn influences total revenue outcomes. If consumers perceive a product as unique or superior, they may see fewer substitutes, making demand more inelastic. In this case, a price increase may not reduce sales much, leading to higher total revenue. Conversely, if a product is perceived as generic or easily replaceable, consumers may be more sensitive to price changes, making demand more elastic. Even a small price increase could lead to a large drop in sales and lower total revenue. Branding, advertising, product differentiation, and customer experience all shape consumer perception. For example, luxury brands often command higher prices because they have cultivated inelastic demand through strong brand identity. If a firm fails to manage how consumers view its product, it may find that changes in price do not have the intended effect on revenue. Strategic perception management is therefore essential for pricing decisions.
Practice Questions
Suppose the price of a product increases from 12 and the quantity demanded decreases from 100 units to 80 units. Explain whether the demand is elastic or inelastic, and describe the impact on total revenue.
The demand is elastic because the percentage decrease in quantity demanded (20%) is greater than the percentage increase in price (20%). This responsiveness indicates that consumers are sensitive to price changes. As a result, when the price increases, total revenue falls—from 960 (12 × 80). In elastic demand situations, price and total revenue move in opposite directions. This demonstrates that increasing the price of a product with elastic demand leads to a decrease in total revenue due to a significant drop in quantity demanded.
A company finds that reducing the price of its product leads to no change in total revenue. What can be concluded about the price elasticity of demand, and how should the firm approach pricing in this case?
If total revenue remains unchanged when the firm changes the price, the demand for the product is unit elastic. This means the percentage change in quantity demanded is exactly equal to the percentage change in price. As a result, changes in price do not affect total revenue. In this case, the firm should understand that altering prices will not increase revenue and may instead focus on improving product quality, advertising, or customer experience to increase sales. Since price changes are ineffective in raising revenue, non-price strategies are more beneficial in a unit elastic demand scenario.
