What this lesson teaches
I can use price, income and cross elasticities to judge how large those changes will be.
Syllabus 9570, 2.1.2(g). Demand and Supply Analysis and its Applications: These outcomes can be affected by price elasticities of demand and supply, income and cross elasticities of demand
Make a guess
A cinema knows its demand is price elastic (PED = -1.5). It raises ticket prices. What happens to its total revenue?
- Revenue falls.
- Revenue stays the same.
- Revenue rises, because each ticket earns more.
Show the answer
Revenue falls.
With elastic demand, quantity falls by a bigger percentage than price rises, so price times quantity falls.
Raise the price if demand is inelastic; cut it if demand is elastic, and revenue rises.
Total revenue (TR) is price times quantity. When price changes, TR can rise or fall. PED tells you which.
If demand is price inelastic, a price rise increases TR. Quantity falls, but by a smaller percentage than the price rises.
If demand is price elastic, a price rise reduces TR, because quantity falls by a bigger percentage. A price cut raises TR instead.
If demand is unit elastic, TR does not change. This is why governments tax goods with inelastic demand, like tobacco and petrol: sales hold up, so tax revenue does too.
- Inelastic
- Raise the price to raise revenue.
- Elastic
- Cut the price to raise revenue.
- Unit elastic
- Revenue unchanged.
| Demand | Price rises | Price falls |
|---|---|---|
| Elastic | TR falls | TR rises |
| Unit elastic | TR unchanged | TR unchanged |
| Inelastic | TR rises | TR falls |
Worked example: Should the cinema raise its price?
Back to the cinema: price rose from $10 to $12, tickets fell from 1,000 to 700 a week, so PED = -1.5.
- TR before: $10 x 1,000 = $10,000.
- TR after: $12 x 700 = $8,400.
- Demand is elastic, so the price rise cut revenue by $1,600.
- To raise revenue, the cinema should cut its price instead, for example with cheaper weekday tickets.
Watch out for this
Raising the price always increases revenue.
Only when demand is price inelastic. With elastic demand, sales fall so much that revenue drops.
Check your understanding
A bus company's PED is -0.4 and it wants more total revenue. What should it do with fares?
- Cut fares, since cheaper trips will attract many more passengers.
- Raise fares, since passengers cut trips by a smaller percentage.
- Keep fares as they are, since inelastic demand fixes total revenue.
Show the answer
Raise fares, since passengers cut trips by a smaller percentage.
Right. With inelastic demand, quantity falls by less than the price rises, so revenue rises.