a) Formulae to calculate and understand the relationship between:
Total revenue is calculated by price x quantity sold – the revenue received from the sale of a given level of output
Average revenue (AR) is the average receipt per unit – calculated by TR/ quantity sold – the price each unit is sold for.
AR curve is the firm’s demand curve – because the average revenue curve is the price of the good
In markets where firms are price takers, the AR curve is horizontal – shows the perfectly elastic demand for their goods
Extra revenue a firm earns from the sale of one extra unit
When marginal revenue is 0 – total revenue is maximised.
The point where MR = 0 on the revenue diagram is directly below the midpoint of the AR curve
This is in the middle of the demand curve – the point where PED = 1
If the prices rise or fall around this point, TR would fall.
b) Price elasticity of demand and its relationship to revenue concepts (calculation required)
In markets where firms are price takers, the AR curve is horizontal.
Because the price received for the good is constant – shows the perfectly elastic demand for their goods.
AR = the demand curve, because AR is the price of the good, and the demand curve shows the relationship between price and quantity. Average revenue = marginal revenue.
If demand is elastic and price increases, the quantity demanded will fall. The effect on total revenue depends on how elastic the demand is.
• E.g. if price rises by 10% and demand decreases by 20%, then the elasticity of demand is +2. This means demand is very elastic and total revenue decreases.
If demand is inelastic and price increases, the quantity demanded will fall (only a small amount) but total revenue will rise – the effect on total revenue depends on how inelastic the demand is.
• If prices rise by 10% and demand decreases by 1%, the PED of demand is +0.1%. Demand is relatively inelastic, and revenue increases.
Usually, the AR curve is downward sloping, because the price per unit is reduced as extra units are sold.