Relationship of Price Elasticity of Demand with Total Revenue and Marginal Revenue

Price elasticity of demand is important in decision-making. It gives the measure of effect of price change in revenues. A given change in price leads to an increase or decrease or no change in total revenue. If the price elasticity accurately estimates, we can estimate accurately the new total revenue after price change.

When demand for a company’s product is elastic, a price cut leads to an increase in total revenue. Its total revenue increases marginal revenue is positive. Because the proportionate rise in the quantity demand more than offsets, the proportionate fall in price. Similarly, when demand is price inelastic, a price cut leads a fall in total revenue. This means that marginal revenue is negative. The reason now is that the percentage increase in the quantity, demanded is not enough to neutralize the percentage fall in price. Finally, if demand for a company’s product is unitary elastic, total revenue remains constant whether price rises or falls. In this situation MR is zero. The reason is easy to find out the percentage change in the quantity demanded and the price are equal but opposite, so that they cancel each other out. These relations can be expanded with the help of diagram.

 

The relations among TR, MR and price elasticity of demand are reviewed in the figure. The top half of the diagram shows a liner demand or AR curve and a corresponding straight line MR curve for a pure monopolist. The bottom of half of the diagram shows the monopolist’s TR curve. The figure shows that the demand is elastic over the range of output O to B. So, TR increases and MR is positive. At the output level of B, the demand is unitary elastic, TR is maximum (output) and MR is zero. Finally, over the range of output from B to T, the demand is inelastic. TR falls as price falls and sales volume increases. Hence MR is negative.

  SOME RELATED LINKS:  

• Elasticity of Demand: Types of Price Elasticity of Demand

• Measurement of Price Elasticity: Total Outlay Method

• Various uses of income and cross elasticity of demand in business decision-making

• Cross Elasticity of Demand: Proportionate change in demand with change in price

• Factors Determining Elasticity of Demand

• Law of Demand: Higher the price, the smaller the quantity demanded

• | Demand | Theory of Demand: desire, willingness and ability to pay for a commodity