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## Relationship between total revenue and elasticity

Hi could someone explain to me what the following means

If demand is elastic, a 1% price cut increases the quantity sold by more than 1%, total revenue increases.
If demand is inelastic, a 1% price cut increases the quantity sold by less than 1%, total revenue decreases.
If demand is unit elastic, a 1% price cut increases the quantity sold by 1%, total revenue does not change.

For example, is my interpretation for the first dot point correct? If a demand is elastic, then the consumer is more sensitive to price changes, thus if the price is cut then the consumer would want to buy more of the good, which means the total revenue for the firm producing the good will increase.

However I am having trouble with my interpretation of the second dot point.

If the demand is inelastic means the consumers are less sensitive to price changes, how does this relate to total revenues decreasing?

Thank you!

Hi TrueTears,

Yes your interpretation of the first dot point is completely correct. If a product is elastic, a price decrease of 1% will result in the quantity demand increase over 1%. This is same for the price increases as well.

The second dot point is also correct, if a product is inelastic, a price decrease of 1% will result in the quantity demanded decrease under 1%.

Since inelasticity shows that consumers are less 'responsive' to the fluctuations of price, firms may lose revenue comparative to the 'optimum' revenue. It's more of a implicit loss, as you could be earning more for the quantity. The opportunity cost is greater if a firm lowers prices than keeping them on hold.

For example, say BP was selling ULP (Unleaded Petrol, which is a highly inelastic good) at $2 a litre and the quantity demanded by customers is 5000 litres. If they decrease the price by 1%, so$1.98 per litre but customers' demand only increased by 0.10% - ~5005 litres then the comparative revenues are:

$2 * 5000 =$10,000

$1.98 * 5005 =$9,910.

So clearly it's not worth dropping the price of fuel by 1% for a gain of 0.10% in the quantity demanded. See how it's more about opportunity costs? Why stick with $90 loss when you can charge higher and obtain$10k in total income.

Instead firms try to capitalise on inelasticity by increasing prices to the optimum level to generate larger income.

I hope that helps :).
Inelastic demand means that a large change in price will only cause a small drop in demand. Generally products for which there is inelastic demand will be those which are relatively cheap to start with, are basic necessities, or have no substitutes.

For example, take cigarettes. Even if the price were to increase significantly, demand would still remain fairly constant (in the short term only, everything is elastic in the long term) as there is no real substitutes for cigarettes, so people would be forced to keep buying them.

Whereas for a product like Pepsi, a small change in price would cause a massive drop in demand as there are plenty of substitutes available, so people would just switch.

Producers of items with inelastic demand are able to maximise revenue easier as they can raise prices without worrying about a drop in demand. (Again, only in the short term.)

Producers of items with elastic demand must pay much more attention to getting the exact right balance in equilibrium price so as to maximise revenue.
Wow, thanks guys, I understand it much better now!
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