September 20, 2013
Using Elasticities to Calculate a Change in Revenue
The example we discussed in class last evening concerns a website developer who is considering
increasing the price of the firm’s services from $200 to $250. The firm is presently selling 12
websites per month and obtaining revenue of $2,400.
Since revenue is simply price times output, we know that a higher price will tend to increase
revenue. At the same time, we know that a higher price will reduce output, and a smaller output
will tend to decrease revenue. Which of the two effects will dominate? In other words, if the
firm raises its price, will its revenues increase or decrease?
The answer depends on the price elasticity of demand. If demand is elastic (i.e., the elasticity
value is greater than 1), then the percentage decrease in quantity demanded will be larger than
the percentage increase in price, and revenue will fall. The opposite is true if demand is
Our example used a price elasticity of demand of 1.8; in other words,
This means that a 1% increase in price will cause a 1.8% fall in quantity demanded, and demand
is elastic. So, if the firm raises its price, its revenues will fall because the percentage fall in
quantity demanded will dominate the percentage rise in price.
We can calculate by exactly how much quantity demanded would fall if the firm raised its price
from $200 to $250 per website. Using the midpoint method for calculating percentage changes,
Therefore, using the elasticity value of 1.8, we know that the quantity demanded will fall by,
Since the 40% fall in the quantity demanded is larger than the 22.2% increase in price, this is
another way of telling us that the firm