Explain the relationship between the price elasticity of demand and total revenu

Question

Explain the relationship between the price elasticity of demand and total revenue. What are the impacts of various forms of elasticities (elastic, inelastic, unit elastic, etc.) on business decisions and strategies to maximize profit? Explain using empirical example.

Is the price elasticity of demand or supply more elastic over a shorter or a longer period of time? Why? Give examples.

What are the impacts of government and market imperfections (failures) on the price elasticities of demand and supply?

Explanation / Answer

* It is important to study the importance between price elasticity of demand and total revenue.

When demand is inelastic, a rise in price leads to rise in total revenue. For example, a 20% rise in price might cause demand to contract only by 5%. In this case, the PED (Price elasticity of demand will be -0.25.

When the price elasticity of demand is elastic, a fall in price will lead to rise in total revenue. For instance, a 10% fall in price might cause demand to expand by 20%. The PED in this case will be +2.5.

When price elasticity is perfectly inelastic, (when PED is zero) a given price change will result in the same revenue change. For instance, a 10% increase in price results in a 10% increase in total revenue. The information on the PED can be used by a business for price discrimination. A supplier can decide to charge different prices for the same product to different segments of the market, for example, peak or off peak rail travel tickets or prices by air travel operators.

* For non-durable goods, elasticity tends to be greater over a long-run than the short-run. For example, if the price of gasoline increases, consumers may continue to fuel their cars in the short-run, but may lower their demand for gas by switching to public transportation over a longer period to time. The demand for durable goods tends to less elastic, as it becomes necessary for consumers to replace them with time.

* Tax incidence decides who will pay the taxes associated with the product, the sellers or the buyer. If supply is more elastic than the demand, the consumer ends up paying more taxes. When demand is more elastic than supply, the seller has to absorb the entire tax burden. Government can use elasticity when establishing taxes for inelastic products. For example, cigarettes and alcohol. The demand for these products is inelastic, increase in taxes will generate significant increase in tax revenues.

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