What is the effect of price reduction on total revenue of a perfectly elastic good?

Price elasticity of demand (PED)

A measure of the resposniveness of the demand for a product to changes in its own price.

Inhaltsverzeichnis Show

Price elasticity of demand (PED)
PED - formula
Elasticity values
Elasticity along a straight line demand curve
What happens to total revenue when price decrease?
How does a change in price affect total revenue when a good is elastic?
What happens to total revenue if a good is elastic?
What happens when the price of an elastic good decreases?

PED - formula

Price elasticity of demand is calculated and defined as:

Price elasticity of demand = % change in Qd / % change in P

Where Qd = Quantity demanded
and P = Price

Some students find it difficult to remember which way up this equation is. The following 'aide memoire' may be of use. You usually put your dinner (demand) on your plate (price). Demand is over price, D over P!

Price elasticity is negative because price and quantity demanded usually vary inversely with each other. This is so common that the sign is ignored. Do not forget, when price increases, demand falls and vice versa.

Elasticity values

Elasticity ranges from zero to infinity and the value is given different names over different numerical ranges as summarised in the table below.

Value	Description	Explanation
O	PERFECTLY INELASTIC	Price has no effect on demand at all
Under 1	INELASTIC	Price has a small effect on demand. The % change in price is larger than the % change in demand
Exactly 1	UNITARY	% Change in price and % change in demand are the same. Remember, though, the signs are different.
Over 1	ELASTIC	Demand is very sensitive to price. The % change in price is less than the % change in demand.
Infinity	PERFECTLY ELASTIC	An infinite amount is demanded at one price but nothing at all at a slightly higher price.

Elasticity along a straight line demand curve

Because of the way that it is calculated, price elasticity will vary along a straight - line demand curve. Examine Figure 1 carefully.

Figure 1 Elasticity along a straight-line demand curve

It is usual to represent the degree of elasticity graphically. The common shapes for demand curves and their elasticity values are given in the diagrams below.

Figure 2 Perfectly inelastic demand curve

Figure 3 Inelastic demand curve

Figure 4 Elastic demand curve

Figure 5 Perfectly elastic demand curve

The special shape that represents a price elasticity of 1 is known as a rectangular hyperbola! This is shown below.

Figure 6 Unit elastic demand curve

Determinants of price elasticity

Price elasticity of a good or service depends on a range of factors:

The availability of close substitutes in the market. The more substitutes available the greater the elasticity.
Is the good a luxury or necessity? Luxuries are more elastic in demand than necessities.
Proportion of income spent on them. Cheap items tend to have an inelastic demand.
Are they addictive? These obviously become price inelastic.
The time period. Elasticity tends to increase with time.
Number of uses

For more detail on any of these factors, follow the links above.

You will be expected to calculate and use elasticity, and to interpret given data. This may happen in any of the papers that are taken. Some examples follow (click on the example links) and there are a series of practice questions which are accessible from the questions section (click on questions - module 2 in the left-hand menu bar).

Example 1 - price elasticity of demand

Example 2 - price elasticity of demand

Elasticity and revenue

Remember that if demand for a good or service is price inelastic then an increase in price will decrease sales but increase sales revenue. However, a price cut will increase both sales but decrease sales revenue.

Firms like the demand for their product if possible to be inelastic. This means that any increase in price that they put in place will have proportionately less of an effect on demand and their total revenue will rise.

If price elasticity is 1, then revenue is the same all the time, even if prices are increased or decreased.

The changes in revenue for different elasticity values are summarised in the table below.

Price elasticity value	Price change	Impact on firm's revenue	Explanation
Elastic	Increase	Fall	Elastic demand will mean that when price increases, demand will fall by a greater percentage than the price increased. This means a fall in revenue.
Elastic	Decrease	Increase	Elastic demand will mean that when price falls, demand will increase by a greater percentage than the price decreased. This means an increase in revenue.
Inelastic	Increase	Increase	Inelastic demand will mean that when price increases, demand will fall by a smaller percentage than the price increased. This means an increase in revenue.
Inelastic	Decrease	Fall	Inelastic demand will mean that when price falls, demand will increase by a smaller percentage than the price decreased. This means a fall in revenue.

What happens to total revenue when price decrease?

A price increase will therefore increase total revenue while a price decrease will decrease total revenue. Finally, when the percentage change in quantity demanded is equal to the percentage change in price, demand is said to be unit elastic. In this case, a price increase or decrease does not change total revenue.

How does a change in price affect total revenue when a good is elastic?

When demand is price inelastic, total revenue moves in the direction of a price change. When demand is unit price elastic, total revenue does not change in response to a price change. When demand is price elastic, total revenue moves in the direction of a quantity change.

What happens to total revenue if a good is elastic?

Total revenue equals total quantity sold multiplied by price of good. With elastic demand – a rise in price lowers total revenue TR increases as price falls. With inelastic demand – a rise in price increases total revenue and TR decreases as price falls.

What happens when the price of an elastic good decreases?

If elastic: The quantity effect outweighs the price effect, meaning if we decrease prices, the revenue gained from the more units sold will outweigh the revenue lost from the decrease in price.