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Elasticity and Revenue
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ECO101
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SSC351--Improving Office Productivity Through TQM
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SSC351 Study Guide

The study of elasticity is incomplete without looking at its effects on revenue. Revenue (or Total Revenue) is the total amount earned by suppliers when they sell goods or services. Revenue must not be confused with profits. Profit is what is left after cost is deducted from revenue. Revenue is calculated simply by multiplying the price of a good or service with quantity sold. For instance, if 20 pencils priced at RM1.00 are sold, then the revenue received is RM20.00. The simple formula to calculate Total Revenue is TR = P x Q, where P is the items price and Q is quantity sold. This simple formula does not mean, however, that by increasing price, a firm will make more profits. In our example for instance, some might think that if the price of pencil is raised to RM1.10 a unit, the firm will get total revenue of RM22.00. Would you believe if I say that the firm will get lower revenue if the price is increased?

What would happen to quantity demanded when price is raised? Applying the law of demand, quantity demanded will fall.  How much is the fall in quantity demanded? This depends on the price elasticity of demand for pencils. Since there are many brands of pencils in the market, I'd say that the demand for pencils is fairly elastic, that is to say, a 1% change in price will cause a more than 1% change in quantity demanded. In our example above, price increases by 10%. Lets say quantity demanded drops from 20 to 10 (a 50% drop). Based on our calculations, a 1% change price results in a 5% change in quantity demanded. Whats the total revenue after the price change? TR = RM1.10 x 10 = RM11.00. You can see here that by increasing the price by a mere 10 sen, the firm loses RM11.00 of revenue! Amazing isn't it?

So, one conclusion we can make about revenue is, for goods with price elastic demand, an increase in price will lower revenue.

Will revenue drop if prices are increased? Well, not necessarily. In the case of goods with price inelastic demand, the opposite is true. Take rice for example. Being a staple food (necessity), its demand is fairly price inelastic. Lets work out an example. Say that at RM1.00 a kilogram, 20 kilograms of rice are demanded. What will happen if price is increased to 1.30 a kilogram? What will definitely happen is that quantity demanded will drop; this is consistent with the law of demand. But, being a price inelastic demand good, the drop is definitely much smaller than the change in price. Let's say that with the new price, quantity demanded drops to 18 kilograms.

At the original price of RM1.00, total revenue is RM20.00 (RM1.00 x 20 kilograms). When the price was raised to RM1.30, total revenue is RM23.40 (RM1.30 x 18 kilograms). You will notice that a 30 sen increase in price raises total revenue by RM3.40 despite the fact that less quantity was sold!

We can conclude that for goods with price inelastic demand, an increase in price will raise revenue.

Application Question: In the recent English Premier League Asia football match between Malaysia and Chelsea, there were only about 25,000 spectators in a stadium that can easily pack 80,000 people. One reason cited for the poor attendance was the ticket price of RM50.00 per unit.  It is very likely that the organizers are now scratching their heads and counting their losses!  If you were the organizers, would you increase or reduce the ticket price? Clue: Decide first whether the demand for football tickets are price elastic or price inelastic.