Elasticity of Demand including Marginal Revenue and the Relationship

with Elasticity of Demand

Section 1, Topic 11, Sept. 19, 2007
Steve Jackson

Price Elasticity of Demand

Price elasticity of demand is defined as the ratio of the relative (or percent)
change in the quantity demanded to the relative change in price. Own price
elasticity of demand is use to help determine the quantitative impact of price
increases and cuts on the firm’s sales and revenues. It is defined by the
following equation:

EQx,Px = %∆Q x
%∆Px

Example: What is the own price elasticity of demand if a 50% increase in

price results in a 17% decrease in quantity sold?

EQx,Px = %∆Q x = - 17% = -0.33

%∆Px 50%

Another way to express the price elasticity of demand is found by the

following equation:

EQ, P = Q 2 – Q 1 x P1
P2 – P1 Q1

This equation is useful when the actual changes in quantity demanded and
changes in price are given.

Example: What is the own price of elasticity of demand if 20 units are sold
at a price of $30, and 10 units are sold at a price of $35?

EQ, P = Q 2 – Q 1 x P1 = (10 – 20) x 30

= -3.00
P2 – P1 Q1 (35 – 30) 20

There are two aspects of the own price elasticity of demand that are
important to accentuate: (1) whether it is positive or negative, and (2) whether
the absolute value is greater or less than 1. The sign is important to
determine the correct increase or decrease in quantity demanded or price.
The absolute value is important to determine the degree of elasticity in the
relationship. The following rules are important to remember:

| EQx,Px| > 1 Demand is elastic

| EQx,Px| < 1 Demand is

inelastic

| EQx,Px| = 1 Demand is unitary elastic

The quantity demanded of a good is responsive to a change in the price
when demand is elastic; relatively unresponsive to a change in price when
demand is inelastic. Unitary elastic means that a change in the price of a
good will have the same change in quantity demanded.

Demand, Elasticity, Marginal Revenue, and Total Revenue

To understand the relationship between demand, elasticity, marginal

revenue, and total revenue, we will need some further definitions. A basic
principle in economics is that total revenue is equal to the quantity multiplied
by the price (TR = P x Q).

Example: If unit price is $25 and the number of units sold is 30, then what
is the total revenue?

TR = P x Q = $25 x 30 = $750

Marginal revenue (MR) is the change in total revenue generated by one

additional unit of product; therefore, by this definition, MR is the slope of the
TR curve. By using calculus methods and taking the derivative with respect
to Q in the TR equation, the formula for MR is:

MR = P [(1 + E) / E]

Example: What is the marginal revenue when price is equal to $30 and
the price elasticity of demand is -3?

MR = P [(1 + E) / E] = $30 [(1 + (-3)) / (-3)] = $20

The relationship between demand, elasticity, marginal revenue and total

revenue can be seen in the table and figures below. This table and figures
are from “Managerial Economics and Business Strategy,” by Baye, and have
been further expanded from the text by adding the marginal revenue column
into the data table and figures. Adding marginal revenue to the figures aids
in visually showing the relationship between demand, elasticity, marginal
revenue, and total revenue.
From the figures, the following table summarizes price changes and its affect
on demand, price elasticity, marginal revenue, and total revenue:

Application of Elasticity of Demand and Marginal Revenue

Price elasticity of demand and marginal revenue can be used by firms to

estimate and predict the effect of a change in price on total revenue. By
knowing the value of the marginal revenue, total revenue can be estimated if
sales changes.

Institutions such as grocery stores, department stores, entertainment, etc.,

can use the price elasticity of demand and its relationship to marginal and
total revenue to determine the effect of prices changes on revenue and
sales.

Example Multiple Choice Questions

1. The price of a firm’s product increases from $4 to $7 and the quantity

demanded of the product declines from 800,000 to 450,000. The price
elasticity of demand for the good is equal to

a. -2
b. -1
c. -0.58
d. 0.58

2. The price elasticity of demand for a firm’s product is equal to -1.6. The firm
currently sells 3,000 units per day at a price of $3. If the firm increases its
product price by 20% then it can expect to sell approximately

a. 2,040 units
b. 3,960 units
c. 1,400 units
d. 1,860 units

3. If the price elasticity of demand for a firm’s product is -3 and the product’s
price is $6, then marginal revenue is equal to

a. $1
b. $2
c. $3
d. $4
4. Which of the following will occur if a company increases the price of a
product when demand is elastic?
a. marginal revenue increases
b. total revenue decreases
c. quantity demanded decreases
d. all of the above

5. Which of the following will occur if a company decreases the price of a

product when the price elasticity of demand is equal to -0.6?

a. marginal revenue increases

b. quantity demanded increases
c. total revenue decreases
d. both b. and c.

Answers to Multiple Choice Questions

1. The solution is found by using the price elasticity of demand equation as

follows:

E = [(Q2 – Q1) / (P2 – P1)] x (P1 / Q1) = [ (450,000 – 800,000) / (7 –

4) ] x (4 / 800,000)

E = - 0.58

2. The solution is found by using the price elasticity of demand equation as in

question 1:

-1.6 = [ (Q2 – 3,000) / (3.6 – 3) ] x (3 / 3,000)

Solving for Q2, Q2 = 2,040 units

3. Using the marginal revenue equation with price and price elasticity of
demand given:

MR = P x [ (1 + E) / E ] = 6 x [ (1 + (-3)) / (-3) ] = $4

4. As found in the figures and tables provided, an increase in price with

elastic demand results in a marginal revenue increase, total revenue
decrease, and quantity demanded decrease. The correct answer is d. all of
the above.

5. When price elasticity is -0.6, then demand is inelastic. A price decrease

will result in a marginal revenue decrease, quantity demanded increase, and
total revenue decrease. The correct answer is d. both b. and c.

References:

http://www.tutor2u.net/economics/revision-notes/as-markets-price-elasticity-
of-demand.html

http://ingrimayne.com/econ/elasticity/RevEtDemand.html

http://en.wikipedia.org/wiki/Marginal_revenue
http://en.wikipedia.org/wiki/Price_elasticity_of_demand

http://www.netmba.com/econ/micro/demand/elasticity/price/

http://www.mackinac.org/article.aspx?ID=1247

Baye, Michael R., "Managerial Economics and Business Strategy", McGraw-

Hill Irwin, 5th Edition. 2006.