Price elasticity of demand can be defined as the degree of responsiveness of demand to the change in price of the product. Mathematically it is the percentage change in quantity demanded produced by 1 percent change in the price of the product. It is ratio of the percentage change in quantity demanded to the percentage change in the price .
The knowledge of the elasticity of demand is quite important for various purposes. The business firm needs to know the elasticity to effectively set its price. The government should also have the knowledge of the elasticity of demand to know which taxation policy will yield more revenue or serve the policy objective better. In this analysis we are going to discuss how the revenue of a firm changes with the price depending upon the price elasticity of demand.
Relation between Revenue and Elasticity of Demand
We know that the total revenue earned by a firm or organization is the product of the price and quantity sold of the product in question. We can write:
TR = P*Q
When elasticity is unitary it implies that a 1% change in price will produce a 1% change in the quantity demanded. So when price rises demand falls by equal proportion and when price falls demand rises by the same proportion as the fall in price . Thus revenue remains unaffected to the change in price when the demand is unitary elastic.
When the demand is price elastic a fall in price will cause a more than proportionate rise in demand and vice versa. So, if price rises by 1% quantity demanded will fall by more than 1% and when price falls by 1% quantity demanded will rise by more than 1%. Let us see what will happen to revenue when price falls and when it rises.
Price fall: When there is a fall in price demand rises more than proportionately. So revenue increases.
Price rise: When price rises demand falls more than proportionately. In this case the revenue will fall.
When demand is inelastic a fall in the price will lead to a less than proportionate rise in the quantity demanded and a rise in price will result in a less than proportionate fall in demand. So when price rises by 1% demand falls by less than 1% and when price falls by 1% demand rises by less than 1%. Let us discuss the effect on revenue when price rises and falls.
Price fall: As price falls demand rises to a lower proportion than the rise in price. In this case the revenue will fall as the price fall dominates the revenue earning.
Price rise: As price rises demand falls but to a lower proportion than the rise in price. Again the rice change dominates and so the revenue rises.
Let us now summarize our discussion on revenue and elasticity. We have seen that for unitary elastic demand there is no change in revenue due to change in price. When demand is elastic a price rise reduces revenue and a price fall increases revenue. When demand is inelastic a price rise raises revenue and a price fall reduces revenue.
The Issue of Price Rise in Nobody State University
The Nobody State University has raised the prices to increase revenue. From the discussion in the previous section we can understand that the rise in the tuition will lead to a fall in revenue if the demand for enrolment in the university is price elastic. The revenue will rise if the demand is price inelastic and remain the same if the demand is unitary elastic.
If the demand is price inelastic the revenue will rise despite the higher tuition as the student enrolment will not fall to any great extent. IF the demand is elastic the student enrolment will fall significantly due to the rise in tuition and lead to a fall in the revenue.
We have been told that the price elasticity of demand for enrollment is -1.2. This implies that the demand is elastic. A raise in the tuition will lead to a fall in enrollment leading to a fall in the revenue for the university. Since the demand is elastic the university should reduce the tuition to increase the revenue as the reduction will lead to large increase in enrollment.
As the president of the NSU I would reduce the tuition in the short run. In the long run I would take measures to improve the course content and other academic facilities in the university so that there is a shift in preference toward this university and the elasticity falls consequently. In such a situation it will be logical to increase the tuition.
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