Before answering how elasticity affects total revenue, you need to recall the following concepts in economics:
- Own-price elasticity of demand. It measures the responsiveness of changes in quantity demanded when prices change. Demand is price elastic when the quantity demanded changes with a percentage higher than the price change. The opposite is price inelastic.
- Law of demand. The price and the quantity demanded have an inverse relationship. When the price goes up, the quantity demanded goes down. In contrast, when prices fall, the quantity demanded rises.
- Total revenue. It is a function of volume and price. You can calculate this by multiplying the price by the quantity sold.
Why elasticity affects total revenue
Knowing the own-price elasticity of demand is essential, especially in pricing strategies.
Companies need to know whether a small increase will cause a decrease in sales. If yes, how significant is the impact of the decline in sales? Is it higher than the price increase?
According to the law of demand, when a company raises prices, it decreases the quantity demanded. So, the effect on total revenue depends on which is more significant, rising prices or falling demand?
How sensitive the quantity of demand decreases when companies increase prices? That is what we call the price elasticity of demand.
So, when raising prices, companies need to analyze the elasticity. When demand is inelastic, the percentage increase in price is higher than the percentage decrease in quantity demanded. The total revenue will increase.
Extreme cases are perfectly inelastic. In this situation, the quantity demanded unchanged, even when prices rise sharply. Thus, companies can generate high revenue. Is this possible?
Some products are close to perfect elasticity. Usually, these products have no substitutes and are necessities. An example is a medicine. You are not likely to replace cancer drugs with heartburn medicine. Or, when your doctor prescribes cancer drugs, you would not replace them with drugs recommended by your colleague’s doctor.
Next, when demand is elastic, total revenue will decrease if the company raises its prices. Elastic means the percentage increase in price is lower than the percentage decrease in quantity demanded.
Extreme cases are perfectly elastic. The demand quantity is to zero when the company raises prices as customers switch to cheaper alternative products. This situation occurs in perfect competition.
The lastest is unitary elastic. The percentage increase in price is equal to the percentage decrease in demand. As a result, total revenue unchanged.
The figure below shows the relationship between elasticity and total income.
See, to increase revenue, companies should:
- Raise prices when demand is inelastic. The percentage increase in price will be higher than the decrease in quantity. For example, when the price rises from $ 1.5 to $ 3, the quantity demanded decreases from 7 units to 5 units. Total revenue still rose from $ 10.5 to $ 15.
- Lower prices when demand is elastic. The percentage decrease in price will be smaller than the increase in quantity. For example, from the price of $ 6 to $ 4.5, the quantity goes up from 1 unit to 3 units. Total income rose from $ 6 to $ 13.5