In order to explain the relationship between total revenue and the price elasticity of demand, people need to understand what total revenue is. Total revenue is the amount paid by buyers and received by sellers of a good. Total revenue is computed as the price of the good times the quantity sold. Since price is part of the equation for total revenue, it is easy to see the relationship between the two, and how a change in price could affect the total revenue of a firm.
By computing the price elasticity of demand, firms could determine if the product or service that they are selling is “price elastic” or “price inelastic.” If the price elasticity value is greater than 1, then the demand for that product is sensitive to price changes. If the price elasticity value equals to 1, then the demand is considered “unit elastic,” and if the price elasticity value is less than 1, then the demand is considered price inelastic to where the demand is not sensitive to price changes at all. When analyzing price elasticity, the absolute value should be used, therefore, ignoring the negative value.
The price elasticity of demand could also assist with determining if a product has “perfect elasticity” or “perfect inelasticity.” Perfect elasticity occurs when even the slightest change in price affects the quantity purchased by consumers. Perfect inelasticity refers to a scenario where customers demand the same quantity of a good no matter how much the price changes. Therefore, if a firm calculates the price elasticity of demand for a certain product and the value from the calculations is “infinite,” then the product has perfect elasticity. If the value from the price elasticity of demand calculation is zero, then the product is considered to have perfect inelasticity. These two concepts are important because if the firm is having difficulties selling a certain product, and they know that the product has perfect elasticity, they could lower the price of that product in an effort to increase the demand for that product, which is in accordance with the “law of demand.” In contrast, if a firm concludes that their product has an elasticity value of zero, then that product is considered as having perfect inelasticity, therefore, the firm would know that changing the price of that product would not affect the demand for that product.
Please note that the price elasticity of demand for a product can have a positive or negative impact on a firm’s total revenue. For example, if a firm determines that their product is price elastic, they could lower the price of that product to increase its’ demand. This would negatively impact the firm’s total revenue because lowering the price of any product automatically lowers the firm’s total revenue. Furthermore, because the firm is now producing more due to the lowered price, it would increase their costs of production due to the additional inputs that are required to produce the additional quantities. If a firm determines that their product is price inelastic, the firm could increase the price of that product to impact positively the firm’s total revenue because regardless of the price, consumers will still have the same demand for that product.
With this in mind, firms need to be careful when making adjustments to price based on the price elasticity of demand because of the impact on total revenue. One of the main goals of businesses owners is to have his or her product reach a state of equilibrium, both in price and in quantity, because they do not want to have a surplus or shortage of that product in the market.
In order to minimize some of the risks associated with the price elasticity of demand on total revenue, firms could use averages to calculate and forecasts future price and the quantity of a certain product. For example, the “midpoint method” could be used when calculating the price elasticity of demand between two points by dividing the percentage change by the midpoint (average) of the initial and final levels. Furthermore, firms need to make sure that they accurately calculate the marginal costs and marginal revenue for that product because of the impact that it has on the total revenue of a firm due to the additional units being produced. If the marginal revenue is greater than the marginal cost, then the firm would know to increase its output. If the marginal cost is greater than the marginal revenue, then the firm would know to decrease its output. In order for a firm to maximize its profits, it needs to produce the quantity at which the marginal cost equals the marginal revenue, thus impacting total revenue positively.