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IB DP Economics — Unit 2: Microeconomics | SL | 2.5 Elasticities of Demand
📋 What You Will Learn
- Define total revenue and explain how it is calculated from price and quantity
- Explain the relationship between PED and changes in total revenue when price changes
- Analyse how elastic, inelastic, and unit elastic demand produce different total revenue outcomes
- Apply the PED–TR relationship to firm pricing decisions and government tax policy
- Evaluate the usefulness of PED as a tool for revenue maximisation in real-world contexts
🔍 Guiding Question When a firm raises its price, does it always earn more revenue — and what determines whether it does or does not?
🌍 Why This Matters In 2023, Netflix raised its standard subscription price in the UK from £10.99 to £13.99 — a 27% increase. Rather than losing revenue, Netflix reported a rise in total subscription income, suggesting demand was inelastic. Meanwhile, Ryanair found that raising prices on competitive European routes caused sharp drops in bookings, reducing revenue. Same action — opposite outcomes. The difference is price elasticity of demand.
Total Revenue — The Starting Point
Before analysing how elasticity affects revenue, we need a precise definition of what total revenue actually is. Firms care about revenue because it determines whether they can cover costs and earn profit.
📖 Definition — Total Revenue (TR) Total revenue is the total income received by a firm from selling a good or service over a given period. It is calculated as the price per unit multiplied by the quantity sold.
Total Revenue Formula
\[ \text{TR} = P \times Q \] Where \( P \) = price per unit and \( Q \) = quantity sold. For example, if a firm sells 500 units at $20 each: TR = $20 × 500 = $10,000.
- On a demand-and-supply diagram, TR is represented by the rectangle formed by the equilibrium price and quantity — height = price, width = quantity
- When price changes, both P and Q change — but in opposite directions (law of demand)
- Whether TR rises or falls depends on which effect dominates : the price effect or the quantity effect
- This is precisely what PED tells us — it measures the relative size of the quantity response to a price change
The PED–Total Revenue Relationship
When a firm changes its price, two forces act on total revenue simultaneously. A price rise increases revenue per unit sold, but the law of demand means fewer units are sold. PED tells us which force wins.
📖 Definition — Price Elasticity of Demand (PED) PED measures the responsiveness of quantity demanded to a change in the price of a good, ceteris paribus. It is calculated as the percentage change in quantity demanded divided by the percentage change in price.
PED Formula
\[ \text{PED} = \frac{\%\Delta Q_d}{\%\Delta P} \] PED is always negative (inverse relationship). For the TR analysis, we use the absolute value |PED| to determine