Question

A price increase has two effects on total revenue: an increase in revenue from higher price, and a fall in revenue from lower quantity due to the law of demand. Which of these two effects is bigger?

1) an increase in revenue from higher price.
2) it depends on the price elasticity of demand.
3) a fall in revenue from lower quantity.

Answer 1

Whether the effect of a price increase on total revenue is bigger due to higher prices or lower quantities sold depends on the price elasticity of demand. If demand is elastic, cutting prices increases total revenue; if demand is inelastic, raising prices does.

Step-by-step explanation:

When considering how a price increase affects total revenue, it is essential to understand the concept of price elasticity of demand. The decision to increase or decrease prices depends on whether demand is elastic, inelastic, or has unitary elasticity at the current quantity level.

For example, if the demand is elastic, a decrease in price will increase the quantity sold enough to result in higher total revenue. Conversely, if the demand is inelastic, an increase in price will not significantly reduce the quantity sold, thus increasing total revenue.

When the demand has unitary elasticity, changes in the price will cause proportional changes in quantity such that total revenue remains unchanged whether prices are moderately increased or decreased.