5 Steps to a 5 AP Microeconomics, 2014-2015 Edition

expensive good. We expect price elasticity to increase as more time passes after the ini-

tial increase in the price.

Example:

If the price of gasoline rises, consumers driving large SUVs do not immediately

switch to small cars and the Edis low for gasoline. But given enough time, if

the gas price remains high, the Edfor gasoline increases.

Total Revenue and Elasticity

Discussing price elasticity and making simple calculations is not just a delightful academic

exercise for students. Knowing how sensitive consumers are to changes in price is impor-

tant to those who benefit from selling goods to those consumers—the sellers. Sellers com-

pute total revenues collected from selling goods.

Total revenue =Price ¥ Quantity demanded

A seller might think, “If I continue to raise the price, my total revenues must continue

to rise.” A student of microeconomics knows that this is flawed logic, because quantity

demanded falls when the price rises, making the impact on total revenue uncertain.

Here’s what’s happening: (Price≠) ¥(Quantity demandedØ)

=Total revenue

With price going up and quantity demanded going down, it’s like a tug-of-war between

two teams, with total revenue being pulled in the direction of the strongest team.

Whether or not the total revenue increases with a price increase depends upon whether

or not the gain from the higher price offsets the loss from lower quantity demanded. Price

elasticity is an excellent way to predict how total revenue changes with a price change. This

is sometimes called the total revenue test. Table 7.2 extends our earlier table by adding a

column for total revenue at points A through G.

Table 7.2

QUANTITY

PRICE PER DEMANDED OF TOTAL = PRICE

POINT CHEESEBURGER CHEESEBURGERS REVENUE P¥Qd ELASTICITY (Ed)

A $0 6 $0 0

B 1 5 5 0.2

C 2 4 8 0.5

D3 3 9 1

E4 2 8 2

F5 1 5 5

G6 0 0 •

As you can see, if the price rises in the inelastic range of the demand curve, total rev-

enues rise. However, if the price continues to rise into the elastic range, total revenues begin

to fall. Why? Maybe a reminder of what it means for demand to be elastic helps to predict

which team wins the tug-of-war.

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Elasticity, Microeconomic Policy, and Consumer Theory ‹ 79

KEY IDEA