Question

Does an increase in price necessarily bring about a higher total revenue?

Short answer

An increase in price does not necessarily bring about a higher total revenue. This depends on the price elasticity of demand for the product in question.

Step-by-step solution

Understand price elasticity of demand

Price elasticity of demand is a measure of the responsiveness of quantity demanded to changes in price. It's calculated as the percentage change in quantity demanded divided by the percentage change in price. If the absolute value of this measure is greater than 1, the product is 'elastic' and sales are sensitive to price. If it’s less than 1, the product is 'inelastic' and sales are not very sensitive to price.

Analyze how price impacts revenue with elastic demand

For products with elastic demand, an increase in price results in a proportionally larger decrease in quantity demanded. Therefore, total revenue (price x quantity) decreases.

Analyze how price impacts revenue with inelastic demand

For products with inelastic demand, an increase in price results in a proportionally smaller decrease in quantity demanded. Therefore, total revenue (price x quantity) increases.

Understand when price change doesn't affect revenue

If the price elasticity of demand is 1 (unit elastic), a percentage increase in price is completely offset by the same percentage decrease in quantity. Therefore, total revenue remains the same.

Key concepts

Elastic Demand

When we talk about elastic demand, we refer to products or services for which consumer demand changes significantly with a small change in price. It's like a rubber band that stretches a lot even when you pull it slightly. In technical terms, elasticity is considered to be greater than 1.

• If you increase the price, the quantity demanded drops sharply.
• This sharp drop in demand leads to a decrease in total revenue (\[\text{Total Revenue} = \text{Price} \times \text{Quantity Sold}\]).

Think of luxury items or products with plenty of alternatives. Consumers will find something else cheaper if the price goes up.
A soda brand with lots of competition might see sales plummet if a small price hike is imposed. Knowing this helps businesses adjust their pricing strategies to avoid losing customers and revenue.

Inelastic Demand

Inelastic demand, on the other hand, describes goods or services for which demand doesn’t change much with a change in price. Imagine a sturdy steel rod that barely bends no matter how hard you push. Here, elasticity is less than 1.

• If the price goes up, the fall in quantity demanded is minor.
• Consequently, total revenue increases because the higher price more than compensates for the lower sales volume.

Essential goods like electricity or gasoline often exhibit inelastic demand. People need these items regardless of price, so sales remain nearly constant.
For instance, a slight increase in fuel prices won’t deter most people from driving their cars, which means oil companies can gain extra revenue.

Unit Elastic Demand

In the case of unit elastic demand, any change in price results in an exactly proportional change in quantity demanded. Think of a perfectly balanced scale that tips equally both ways. Here, elasticity is equal to 1.

• If the price increases by a certain percentage, the quantity demanded decreases by the exact same percentage.
• Total revenue remains unchanged because the effect of price and quantity offsets each other perfectly.

This scenario is rare as it requires the demand to be perfectly responsive, but it's helpful for theoretical insight. Imagine a product where a% increase in price leads to the same % decrease in demand.
In such a case, no matter how you tweak prices, the revenue stays the same, making it a neutral zone for pricing strategies.