If demand is elastic, a price cut raises revenue; if demand is inelastic, a price rise raises revenue.
Total revenue (TR) is price x quantity sold. It is the same as the total amount consumers spend on the good. PED tells a firm what happens to TR when it changes price.
If demand is elastic, a price cut raises TR. Quantity rises by a bigger percentage than price falls. A price rise reduces TR.
If demand is inelastic, a price rise raises TR. Quantity falls by a smaller percentage than price rises. A price cut reduces TR.
If demand is unitary, TR does not change when price changes. On a diagram, compare the revenue lost on existing units with the revenue gained on extra units.
- Total revenue
- Price x quantity sold; equals consumer expenditure.
- Elastic demand
- Price cut raises revenue; price rise lowers it.
- Inelastic demand
- Price rise raises revenue; price cut lowers it.
- Unitary
- Revenue unchanged when price changes.
Worked example: Calculating the change in revenue
Suppose a bakery raises the price of a loaf from $3.00 to $3.30. Daily sales fall from 400 to 380.
- Old revenue: $3.00 x 400 = $1,200.
- New revenue: $3.30 x 380 = $1,254. Revenue rises by $54.
- Check with PED: quantity falls 5% and price rises 10%, so PED = -0.5. Demand is inelastic.
- Conclusion: with inelastic demand, the price rise increased revenue, as predicted.
Watch out for this
A price cut always raises revenue because more is sold.
More is sold, but each unit earns less. Revenue rises only if demand is elastic. With inelastic demand, a price cut lowers revenue.
Check your understanding
Demand for a firm's product has a PED of -0.4. What should the firm do to raise total revenue?
- Raise the price
- Cut the price
- Nothing; price changes never affect revenue