Total Revenue Method.pptx

http://www.bized.ac.uk
Copyright 2005 – Biz/ed
2
The Total Revenue Method
• The total revenue
method is the
simplest way of
telling whether
demand is elastic,
inelastic.

3
• The total revenue
that would be
received by
sellers at various
prices is found by
multiplying price
by quantity
demanded.

4
• When total
revenue moves in
the opposite
direction to the
price change,
demand is elastic.
• Example:
Price TR
Price TR

5
• At $1 consumers demand 100
units and the revenue equals
$100.
• At 99c consumers demand 105
units and revenue equals $103.95.
• By price, Revenue . Demand
is therefore elastic.

6
• Total revenue remains the
same when prices change if
demand has unit elasticity.
• At $1 consumers demand 99
units and revenue equals
$99.
• At 99c consumers demand
100 units and revenue
equals $99

7
• The price change
has not resulted
in any change in
revenue.
• Demand is
therefore unitary
elastic.

Total Revenue Method
Price
Quantity Demanded (000s)
D
The importance of elasticity
is the information it
provides on the effect on
total revenue of changes in
price.
$5
100
Total revenue is price x
quantity sold. In this
example, TR = $5 x 100,000
= $500,000.
This value is represented by
the grey shaded rectangle.
Total Revenue

Elasticity
Price
Quantity Demanded (000s)
D
If the firm decides to
decrease price to (say) $3,
the degree of price
elasticity of the demand
curve would determine the
extent of the increase in
demand and the change
therefore in total revenue.
$5
100
$3
140
Total Revenue

inelasticity
Price ($)
Quantity Demanded
10
D
5
5
6
% Δ Price = -50%
% Δ Quantity Demanded = +20%
Ped = -0.4 (Inelastic)
Total Revenue would fall
Producer decides to lower price to attract sales
Not a good move!

Elasticity
Price ($)
Quantity Demanded
D
10
5 20
Producer decides to reduce price to increase sales
7
% Δ in Price = - 30%
% Δ in Demand = + 300%
Ped = - 10 (Elastic)
Total Revenue rises
Good Move!

Total Revenue
Let's imagine we operate a small canteen in a school. I
might say to you ''increasing the price of a can of Brand
''X'' soft drink from $1.00 per can to $1.40 per can is not a
good idea. Our customers will buy Brand ''Y'' instead.'‘

• ''At the moment, we are selling 200 cans per day of Brand ''X'',
at $1.00 per can.
• We are generating $1.00 per can x 200 cans = $200 per day in
revenue from sales of Brand ''X''.
• I believe that we will only sell 120 cans per day if we increase
the price of Brand ''X'' to $1.40 per can; resulting in a daily
revenue of ?
• $1.40 per can x 120 cans = $168.

• Calculate the revenue gained
• The revenue we gain from increasing the price per can ($0.40 x
120 = $48)
• Calculate the revenue lost
• Will the revenue gained offset the revenue lost?
• It will not be enough to offset the revenue we will lose from the
decrease in the quantity of cans we sell ($1.00 x 80 = $80).''
• I show your reasoning, on a Supply and Demand diagram
• What is the reason for your conclusion? Why do you think this
might be the case?
• Implicit in my reasoning is my belief that Brand ''X'' has a close
substitute in Brand ''Y'', and that Brand ''X'' is price elastic.

• You, however, are more in touch with teenage trends and
fashion than I am.
• You reply ''Brand ''X'' is really popular at the moment. I
believe we can increase the price to $1.40 per can. We
will lose very few sales'‘.
• Using a Demand and Supply model show me your
analysis of the market for brand ''X”, based on the
belief that an increase in price to $1.40 per can will
only cause a loss of 10 cans in sales per day.

The revenue gain from the increase in price ($0.40 x 190
cans = $76) will more than compensate for the revenue
loss caused the decrease in quantity sold ($1.00 x 10 =
$10)
You have correctly noticed that Brand ''X'' is price
inelastic, and that an increase in price will generate
more net revenue.

Elasticity
• If demand is price
elastic:
• Increasing price would
reduce TR (%Δ Qd > %
Δ P)
• Reducing price would
increase TR
(%Δ Qd > % Δ P)
• If demand is price
inelastic:
• Increasing price would
increase TR
(%Δ Qd < % Δ P)
• Reducing price would
reduce TR (%Δ Qd < %
Δ P)

Mid point method
• There is a more accurate method to calculating
elasticity
• This because a percent change in a given
problem could be different depending on
whether the price is increasing, or falling.
• Check out the example below for a price
change from $5 to $10:
•
• If the price increases to $10, then we have
($10-$5)/$5, which gives us $5/$5, or 100%
•
• However if the price decreases we have ($5-
$10)/$10, which gives us -$5/$10, or -50%.
• depending on whether it is a price increase or
decrease, then we will see different percentage
values.
• But if we use the midpoint formula, this won’t
be a problem.
• Let us look at our example above again.

Mid point method
• Formula is as follows – first step find average
• Where Xaverage is the sum of the old and new values divided by 2. i.e.
• if price increased from 10 dollars to 12 dollars,
• (12 + 10)/2 = 11 Ave P
• If quantity demanded fell from 30 to 20 items
• (20 + 30)/2 = 25 Ave Q
•
midpoint
elasticity
=
Ave P
Δ Price
X
ΔQ
Ave Q

The percentage change in price, calculated by the midpoint formula would be
2/11 = 18.2 percent
The percentage change in quantity, calculated bye the midpoint formula would
be
10/25 = -40 percent
And the coefficient of elasticity, calculated by the midpoint formula is
-40/18.2 = -2.2
The answer is negative because as the price goes up, we consume less of the
good (which follows the law of demand).

• Have a go at the following
• Price increase from $8 to $9
• Quantity changes from 60,000 to 45,000
• Calculate using mid point method

• Calculate averages first i.e (45,000 + 60,000) /2 =
•
midpoint
elasticity
=
8.5
1
X
15,000
52,500
= 2.43

Factors affecting Elasticity of Demand
• Time period – the longer the time under consideration the
more elastic a good is likely to be.
• Short run demand relatively inelastic no time to adjust, long
run demand relatively elastic E.g. installing LPG in car, trading
car in on a hybrid
• Number and closeness of substitutes – the greater the
number of substitutes the more elastic. Brands of petrol
• Price elasticity of a brand is greater than the price elasticity of
a good

Factors affecting Elasticity of Demand
• The proportion of income taken up by the
product – the smaller the proportion the more
inelastic
• Expensive goods are likely to be relatively price
elastic Why?
• Because they take up a larger proportion of
income
• Luxury or Necessity – necessity goods such as
food & drugs will be price inelastic
• Luxury items will be price elastic

Total Revenue Method.pptx

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Total Revenue Method.pptx