Understanding the Relationship Between Total Revenue and Elasticity Review: Total revenue is price times quantity demanded: TR = P x Q. Review: Elastic demand indicates price sensitivity; inelastic demand indicates price insensitivity. When price changes, you can analyze the change in total revenue in terms of a price effect and a quantity effect. Elasticity determines which effect is greater after a change in price. Begin this section by reviewing the formula for total revenue: TR = P x Q. The box on the left summarizes the relationship between price changes, total revenue, and elasticity: 1. With products that are price-sensitive, or elastic, a percentage change in price means a greater percentage change in quantity demanded. Total revenue and price move in opposite directions. 2. With products that are price-insensitive, or inelastic, a percentage change in price means a smaller percentage change in quantity demanded. Total revenue and price move in the same direction. Using math shows that the relationships on the left are true. The mathematical relationship above is analogous to the formula for finding a change in total revenue when the price changes. The formula in the lower part of the box on the left says that the percentage change in total revenue is equal to the percentage change in price + the percentage change in quantity demanded. Assume that the change in price is an increase. A price increase means that there will be a decrease in quantity because the demand curve is downward sloping. By manipulating the equation, you can see that the last term on the right is the formula for elasticity. If the elasticity is less than 1, as it is here, then the product has inelastic demand. The price effect is the increase in revenue from selling the product at a higher price. The quantity effect is the decrease in revenue from the fall in quantity demanded caused by the increase in price. In this case, the price effect has dominated. The increase in price has not caused a large loss of customers. There has not been a large decrease in quantity demanded, or a large quantity effect. Therefore the increase in total revenue from the price effect is greater than the decrease in total revenue from the quantity effect. To summarize: If the quantity effect dominates, then elasticity is greater than 1 (demand is elastic), and total revenue and price move in opposite directions. If the price effect dominates then elasticity is less than 1 (demand is inelastic), and total revenue and price move in the same direction.