Total Revenue and Elasticity

Understanding Total Revenue

Total revenue is the total amount of money received from the sale of a good, calculated as the price of the good multiplied by the quantity sold.

• Formula:

• When the price of a good changes, total revenue also changes, but not always in a straightforward way.

Elasticity of Demand and Its Effect on Total Revenue

The effect of a price change on total revenue depends on the price elasticity of demand:

• Elastic Demand: A 1% price cut increases the quantity sold by more than 1%, causing total revenue to increase.

• Inelastic Demand: A 1% price cut increases the quantity sold by less than 1%, causing total revenue to decrease.

• Unit Elastic Demand: A 1% price cut increases the quantity sold by exactly 1%, so total revenue does not change.

Graphical Representation

Figure 4.5 illustrates the relationship between elasticity and total revenue using the example of pizza sales:

• At high prices (e.g., $25), demand is elastic. Lowering the price increases total revenue.

• At low prices (e.g., below $12.50), demand is inelastic. Lowering the price decreases total revenue.

• At the midpoint price ($12.50), demand is unit elastic, and total revenue is maximized.

Total Revenue Test

The total revenue test is a practical method for estimating the price elasticity of demand by observing how total revenue changes as price changes (holding all other factors constant):

• If a price cut increases total revenue, demand is elastic.

• If a price cut decreases total revenue, demand is inelastic.

• If a price cut leaves total revenue unchanged, demand is unit elastic.

Example Application

• Suppose the price of pizza drops from $25 to $12.50. If total revenue rises, demand is elastic in this range.

• If the price drops further from $12.50 to $0 and total revenue falls, demand is inelastic in this range.

• At $12.50, total revenue is at its maximum, indicating unit elasticity.

Summary Table: Elasticity and Total Revenue

Key Formula:

Additional info: The total revenue test is a foundational tool in microeconomics for analyzing consumer behavior and market outcomes, especially when direct calculation of elasticity is difficult.