Lets start with some basics.
Total Revenue = Price of individual goods or service x quantity of product sold
If Unit Elasticity was in effect, ie the Elasticity of Demand was equal to 1, then a 1% rise in price would result in a 1% drop in demand (and vice versa) assuming that the correlation was a negative one
i.e Ed = (-)1.
But this is unlikely to be found in the real world, in particular for anything more than a small stretch of the demand curve.
When the elasticity of demand is seen to be inelastic (ie Ed < 1 ) is can be seen:
- an increase in Po causes a reduction in Q but an increase in revenue.
- a decrease in Po causes as increase in Q but a decline in revenue.
When the elasticity of demand is said to be elastic (Ed > 1 ) it can be seen:
- an increase in Po causes a reduction in Q but a decrease in revenue.
- a decrease in Po causes causes an increase in Q but an increase in revenue.
Marginal Revenue is the change in total revenue seen as the firm sells one more unit of its product.
MR = change in TR / change in Q
This is the total revenue divided by the output, or simply put the average revenue achieved per product sold.
AR = TR/Q
It is obvious to see that when the price per unit is equal the average revenue is the revenue achieved for per product sold and therefore the demand curve is also the average revenue curve.
There are some key relationships to notice from the graphs above:
- Marginal Revenue falls as output rises. Since the demand curve slopes downward the additional revenue per extra unit decreases. This demonstrates the Law of Diminishing Marginal Returns.
- Average Revenue exceeds Marginal Revenue when the slope of the demand curve is negative.
- Marginal Revenue curve declines at twice the rate than the Demand Curve (also the revenue curve as stated above). Note the MR curve cuts midway between OC.
- Total Revenue increases whilst MR is positive. This is due to the elastic nature of demand from AB on DD.
- Total Revenue falls whilst MR is negative. This is due to the inelastic nature of demand from BD on DD.
- Total revenue is maximised when MR is ‘0’, which is seen when unit elasticity is reached.
Please note that during these discussions and examples all other factors are ceteris paribus.