90 Reading: Elasticity and Total Revenue
Total Revenue and Elasticity of Demand
Studying elasticities is useful for a number of reasons, pricing being the most important. The key consideration when thinking about maximizing revenue is the price elasticity of demand. Total revenue is the price of an item multiplied by the number of units sold: TR = P x Qd. When a firm considers a price increase or decrease, there are three possibilities, which are laid out in Table 1, below.
Table 1. Price Elasticity of Demand
| If demand is . . . | Then . . . | Therefore . . . |
| Elastic | % change in Qd is greater than % change in P | A given % rise in P will be more than offset by a larger % fall in Q so that total revenue (P times Q) falls. |
| Unitary | % change in Qd is equal to % change in P | A given % rise in P will be exactly offset by an equal % fall in Q so that total revenue (P times Q) is unchanged. |
| Inelastic | % change in Qd is less than % change in P | A given % rise in P will cause a smaller % fall in Q so that total revenue (P times Q) rises. |
If demand is elastic at a given price level, then the company should cut its price, because the percentage drop in price will result in an even larger percentage increase in the quantity sold—thus raising total revenue. However, if demand is inelastic at the original quantity level, then the company should raise its prices, because the percentage increase in price will result in a smaller percentage decrease in the quantity sold—and total revenue will rise.
Let’s explore some specific examples. In both cases we will answer the following questions:
- How much of an impact do we think a price change will have on demand?
- How would we calculate the elasticity, and does it confirm our assumption?
- What impact does the elasticity have on total revenue?
Example 1: The Student Parking Permit
How elastic is the demand for student parking passes at your institution? The answer to that question likely varies based on the profile of your institution, but we are going to explore a particular example. Let’s consider a community college campus where all of the students commute to class. Required courses are spread throughout the day and the evening, and most of the classes require classroom attendance (rather than online participation). There is a reasonable public transportation system with busses coming to and leaving campus from several lines, but the majority of students drive to campus. A student parking permit costs $40 per term. As the parking lots become increasingly congested, the college considers raising the price of the parking passes in hopes that it will encourage more students to carpool or to take the bus.
If the college increases the price of a parking permit from $40 to $48, will fewer students buy parking permits?
If you think that the change in price will cause many students to decide not to buy a permit, then you are suggesting that the demand is elastic—the students are quite sensitive to pr