Elasticity and Revenue

2/17/2019 4.
2 Elasticity and Revenue – Principles of Microeconomics
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PRINCIPLES OF MICROECONOMICS
CONTENTS
Topic 4 Part 1: Elasticity
4.2 Elasticity and Revenue
Learning Objectives
By the end of this section, you will be able to:
Analyze graphs in order to classify elasticity as constant unitary, infinite, or zero
Describe the price effect and the quantity effect
Analyze how price elasticities impact revenue and expenditure
In Topic 4.1, we introduced the concept of elasticity and how to calculate it, but we didn’t ex
plain why it is useful. Recall that elasticity measures responsiveness of one variable to changes
in another variable. If you owned a coffee shop and wanted to increase your prices, this ‘re
sponsiveness’ is something you need to consider. When you increase prices, you know quantity
will fall, but by how much?
Previous: 4.1 Calculating Elasticity
Elasticities can be divided into three broad categories: elastic, inelastic, and unitary. An elastic
demand is one in which the elasticity is greater than one, indicating a high responsiveness to
Next: 4.3 Relative Elasticity
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2/17/2019 4.2 Elasticity and Revenue – Principles of Microeconomics
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changes in price. Elasticities that are less than one indicate low responsiveness to price changes
and correspond to inelastic demand. Unitary elasticities indicate proportional responsiveness
of either demand or supply, as summarized in the following table:
If . . . Then . . . And It Is Called . . .
Elastic
Unit Elastic
Inelastic
Elastic, Inelastic, and Unitary: Three Cases of Elasticity
If we were to calculate elasticity at every point on a demand curve, we could divide it into
these elastic, unit elastic, and inelastic areas, as shown in Figure 4.2a. This means the impact
of a price change will depend on where we are producing. Feel free to calculate the elasticity in
any of the regions, you will find that it indeed fits the description.
Figure 4.2a
To demonstrate, we have calculated the elasticities at a point in each of the zones:
Point A = = Elastic
Point B = = Inelastic
Point C =
Previous: 4.1 Calculating Elasticity = Unit Elastic
In reality, the only point we need to find to determine which areas are elastic and inelastic is
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our point where elasticity is 1, or Point C. This isn’t as hard as it may seem. Since our formula
is equal to the inverse of our slope multiplied by a point on the graph, it will only equal 1 when
our point is equal to the slope of our graph. For a linear graph, this only occurs at the middle
point, which is (4.5, 3.325) in this case.
Why is This Useful?
So far,
we have
deter
mined
how to
calculate
elasticity
at and be
tween dif
ferent
points, but
why is
this
When Starbucks runs a buy one get one free promotion, they effectively lower the price of a drink by
50%. The company sells more drinks, but at a lower price. Elasticity determines whether or not this knowl
promotion will be profitable. Of course, promotions are not always intended to be profitable in the short
term. Oftentimes, firms will cut prices to increase awareness of their new products, as Starbucks does edge
with its holiday drinks. (Credit: Starbucks) useful?
Consider a coffee shop owner considering a price hike. The owner has two things to account
for when deciding whether to raise the price, one that increases revenue and one that decreases
it. Elasticity helps us determine which effect is greater. Referring back to our table:
1. When you increase price, you increase revenue on units sold (The Price Effect).
2. When you increase price, you sell fewer units (The Quantity Effect).
These two effects work against eachother. To determine which outweighs the other we can
look at elasticity:
When our point is elastic our meaning if we in
crease price, our quantity effect outweighs the price effect, causing a decrease in revenue.
When our point is inelastic our
meaning if we in
crease price, our price effect outweighs the quantity effect, causing a increase in revenue.
This information is summarized in Figure 4.2b: Increase Font Size
The first thing to note is that revenue is
maximized at the point where elasticity is
unit elastic. Why? If you are the coffee
shop owner, you will notice that there are
untapped opportunities when demand is
elastic or inelastic.
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.
If inelastic: The price effect outweighs
the quantity effect, meaning if we in
crease prices, the revenue gained from the
higher price will outweigh the revenue
lost from less units sold.
Figure 4.2b
The effects of price increase and decrease
at different points are summarized in Figure 4.2c.
Figure 4.2c

What about Expenditure Increase Font Size
You will notice that expenditure is mentioned whenever revenue is. This is because a dollar
earned by the coffee shop corresponds to a dollar spent by the consumer. Therefore, if the
firm’s revenue is rising, then the consumer’s expenditure is rising as well. You must understand
how to answer questions from both sides.
Summary
Elasticity is used to measure the responsiveness of one variable to another. This responsive
ness can be labelled as elastic (e > 1), unit elastic (e = 1), and inelastic (e < 1). We can apply
this to the demand curve, with unit elastic corresponding to the middle of the demand curve (x
intercept/2 , yintercept/2). Everything to the left is elastic and everything to the right is inelas
tic. This information can be used to maximize revenue or expenditure, with the understanding
that when elastic, the quantity effect outweighs the price effect, and when inelastic, the price
effect outweighs the quantity effect.
Glossary
Elastic
when the elasticity is greater than one, indicating that a 1 percent increase in price will result in a
more than 1 percent increase in quantity; this indicates a high responsiveness to price.
Inelastic
when the elasticity is less than one, indicating that a 1 percent increase in price paid to the firm will
result in a less than 1 percent increase in quantity; this indicates a low responsiveness to price.
Unitary elastic
when the calculated elasticity is equal to one indicating that a change in the price of the good or
service results in a proportional change in the quantity demanded or supplied
Exercises 4.2
Use the demand curve diagram below to answer the following TWO questions.
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1. What is the ownprice elasticity of demand as price decreases from $8 per unit to $6
per unit? Use the midpoint formula in your calculation.
a) Infinity.
b) 7.0
c) 2.0.
d) 1.75

2. At what point is demand unitelastic?
a) P = $6, Q = 12.
b) P = $4, Q = 8.
c) P = $2, Q = 12.
d) None of the above.

3. Which of the following statements about the relationship between the price elasticity
of demand and revenue is TRUE?
a) If demand is price inelastic, then increasing price will decrease revenue.
b) If demand is price elastic, then decreasing price will increase revenue.
c) If demand is perfectly inelastic, then revenue is the same at any price.
d) Elasticity is constant along a linear demand curve and so too is revenue.

4. Suppose BC Ferries is considering an increase in ferry fares. If doing so results in an
increase in revenues raised, which of the following could be the value of the ownprice
elasticity of demand for ferry rides?
a) 0.5.
b) 1.0.
c) 1.5. Increase Font Size
d) All of the above.

5. Use the demand diagram below to answer this question. Note that P × Q equals $900
at every point on this demand curve.
Which of the following statements correctly describes ownprice elasticity of demand,
for this particular demand curve?
I. Demand is unit elastic at a price of $30, and elastic at all prices greater than $30.
II. Demand is unit elastic at a price of $30, and inelastic at all prices less than $30.
III. Demand is unit elastic for all prices.
a) I and II only.
b) I only.
c) I, II and III.
d) III only.

6. Suppose that, if the price of a good falls from $10 to $8, total expenditure on the good
decreases. Which of the following could be the (absolute) value for the ownprice elastic
ity of demand, in the price range considered?
a) 1.6.
b) 2.3.
c) Both a) and b). Increase Font Size
d) Neither a) or b).

7. Consider the demand curve drawn below.
At which of the following prices and quantities is revenue maximized?
a) P = 40; Q = 0.
b) P = 30; Q = 5.
c) P = 20; Q = 10.
d) P = 0; Q = 20.
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2/17/2019 4.

2 Elasticity and Revenue – Principles of Microeconomics

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Topic 4 Part 1: Elasticity

4.2 Elasticity and Revenue

If . . . Then . . . And It Is Called . . .

Why is This Useful?

What about Expenditure Increase Font Size

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