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Roll No : 531010794
Question No.1 : Mention the demand function. What is elasticity of demand? Describe the
determinants of elasticity of demand.

Answer

DEMAND FUNCTION
Definition: It is a behavioral relationship between quantity consumed and a person's maximum
willingness to pay for incremental increases in quantity. It is usually an inverse relationship where
at higher (lower) prices, less (more) quantity is consumed. Other factors which influence
willingness-to-pay are income, tastes and preferences, and price of substitutes

Factors affecting market demand

Market or aggregate demand is the summation of individual demand curves. In addition to the
factors which can affect individual demand there are three factors that can affect market demand
(cause the market demand curve to shift):

 a change in the number of consumers,

 a change in the distribution of tastes among consumers,
 A change in the distribution of income among consumers with different tastes.

Mathematically, a demand function can be represented in following manner:

Dx=f (Ps, Pc, Ep, Y, Ey, T,W,A,U……..)

Where Dx= Demand for commodity X, Ps= Price of substitutes, Pc=Price of complement

Ep=Expected future price, Y= Income of consumer, T= Taste and preferences

A= advertisement, U= other determinants.

The knowledge of demand function is more important for a firm than the law of demand. Demand
function explains the various factors and forces other than price that would affect the demand for
commodity in the market. In accordance with changes in different factors, a firm can take suitable
measures to prepare the production, distribution and marketing programmes systematically.

ELASTICITY OF DEMAND

Definition: Responsiveness of the demand for a good or service to the increase or decrease in its
price. Normally, sales increase with drop in prices and decrease with rise in prices. As a
general rule, appliances, cars, confectionary and other non-essentials show elasticity of demand
whereas most necessities (food, medicine, basic clothing) show inelasticityof demand (do
not sell significantly more or less with changes in price)It is generally defined as the
responsiveness or sensitiveness of demand to a given change in price of commodity. It refers to
capacity of demand either to stretch or shrink to a given change in price.

Elasticity of demand indicates a ratio of relative changes in two quantities i.e. price and
demand. In words of Marshall “The elasticity of demand in a market is great or small according to
as amount demanded much or little for a given fall in price and diminishes much or little for a given
rise in price.
DETERMINANTS OF ELASTICITY OF DEMAND

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The major nonprice determinants of demand are: (1) income, (2) tastes and preferences, (3) the
price of related goods, (4) changes in expectations of future relative prices, and (5) population (i.e.,
market size).

The major nonprice determinants of supply are: (1) input costs, (2) technology, (3) taxes and
subsidies, (4) expectations of future relative prices, and (5) the number of firms in the industry.

Substitutes: a change in the price of one causes a shift in demand for the other in the same
direction (e.g. butter and margarine)

Complements: a change in the price of one good causes a shift in demand for the other in the
opposite direction (e.g., stereo amplifiers and speakers, nuts and bolts)

The elasticity of demand depends on several factors of which following are some of the important
ones:

Nature of the commodity: Essential commodities that are required on a daily basis such as rice,
wheat, sugar, milk tends to be inelastic while luxury items like T.V., refrigerators, DVD tends to be
elastic.

Existence of Substitutes: If commodity has no substitutes in market demand tends to be

inelastic, because people have to higher price for such articles such as gas, petrol, salt. Whereas
commodities having different substitutes, demand tends to be elastic e.g. soaps, toothpastes.

Number of users for commodities: For single use products like eatables, furnitures tends to be
inelastic but for commodities having multiple uses like elasticity, steel demand tends to be elastic.

Durability and reparability: Demand tends to be elastic in case of durable and repairable goods
like table, chairs. On the other hand, perishable goods like fish, milk demand tends to be inelastic.

Possibility of postponing use of commodity: Commodities like medicine cannot be postponed,

so it is inelastic. Buying scooters, cars demands can be postponed, so it is elastic.

Level of income of people: In case of rich people demand will be inelastic whereas for poor
people it tends to be elastic

Range of prices: Certain goods which are relatively expensive or relatively cheap like cars or
needle, small rise or fall in price will not affect the demand, so demand tends to be inelastic but for
commodities having normal price range tends to be elastic.

Other determinants like proportion of expenditure on commodity, Habits, Period of time, Level of
knowledge of the customers, purchase frequency of a product can also determine the elasticity of
demand.

Determinants of price elasticity of demand

1. Existence of substitutes—the closer the substitutes for a particular commodity, the greater
will be its price elasticity of demand

2. Importance of the commodity in the consumers budget—the greater the percentage of a

total budget spent on the commodity, the greater the person’s price elasticity of demand
for that commodity

3. Time for adjustment in rate of purchase—the longer any price change persists, the greater
the price elasticity of demand

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FACTORS THAT SHIFT THE DEMAND CURVE

• Change in consumer tastes

• Change in the number of buyers
• Change in consumer incomes
• Change in the prices of complementary and substitute goods
• Change in consumer expectations

Question No.2 : How is demand forecasting useful for managers ?

Answer

DEMAND FORECASTING FOR MANAGERS

Importance of forecasts

Understanding and predicting customer demand is vital to manufacturers and distributors to avoid
stock-outs and maintain adequate inventory levels. While forecasts are never perfect, they are
necessary to prepare for actual demand. In order to maintain an optimized inventory and effective
supply chain, accurate demand forecasts are imperative

Calculating the accuracy of supply chain forecasts

Forecast accuracy in the supply chain is typically measured using the Mean Absolute Percent
Error or MAPE. Statistically MAPE is defined as the average of percentage errors. Most practitioners,
however, define and use the MAPE as the Mean Absolute Deviation divided by Average Sales. This
is in effect a volume weighted MAPE. This is also referred to as the MAD/Mean ratio.

Demand forecasting issues

There are several ways that demand forecast distributions can be evaluated. Our simulations
provide several thousand sample paths for each year in the future, up to about 10 years ahead.
These can be used to produce different forecast distributions such as the following examples.

1. The overall demand distribution for a randomly chosen half-hour period in a summer;

2. The demand distribution for a specific half-hour period (e.g., 3pm) on a randomly chosen
day in summer.

3. The demand distribution for a specific half-hour period on a specific day in summer (e.g.,
3pm on 15 February).

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4. The distribution of the maximum half-hourly demand for a specific one-week period in
summer.

5. The distribution of the maximum half-hourly demand for any period in a summer.

Demand Forecasting can be useful for the Manager both in the short run as well as in the long run.

In the short run: Demand forecasts for short period of time is made on the assumption that the
company has a given production activity and the Manager has a short period notice (maybe 1 year)
to change the existing production capacity.

Production Planning: It helps in determining the level of output at various periods and avoiding
under or over production.

Helps to formulate right purchase policy: It helps in controlling the inventory level by buying
inputs, which will help in operational cost cutting.

Helps to frame realistic pricing policy. A rational pricing policy can be formulated to suit short
run and seasonal variations in demand.

Sales forecasting. It helps company in setting realistic targets both at individual as well as
organizational level.

Helps in estimating short run financial requirements for achieving the sales and production targets.

It reduces the dependence on chances and also helps to evolve a suitable labour policy’s. Exact
requirement of laborers required in the production as well as sales team.

• In the long run: Long run forecasting for the demand of a product is generally from a
period of 3 to 5 to 10 years. It helps a Manager in the following ways:

Business Planning: It helps in planning the expansion of existing unit or starting a new unit.
Capital budgeting of a firm is based on long run demand forecasting.

Financial Planning: It helps to plan long run financial requirements and investment programs by
floating shares and debentures in the open market.

Manpower Planning: It helps the manager in planning for the training needs of the existing staff
and recruiting skilled and efficient staff for its long run growth.

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Business Control: By effective control over total costs and revenues of a company it helps to
determine the value and volume of business and helps in estimating the profits of the firm. This
helps in effective business management and the firm can meet challenges more optimistically.

 A steady and well conceived demand forecasting can help in predicting the growth rate
of the company.

 It also helps in reducing production uncertainties and help in stabilizing the activities of
the firm.

 Demand forecasts of certain products becomes the basis of demand forecasts for related
companies

It is more useful in developed nations, where demand conditions fluctuate more than supply
conditions.

Question No.3 : Explain production function. How is it useful for business?

Answer

PRODUCTION FUNCTION

A production function is a function that specifies the output of a firm, an industry, or an entire
economy for all combinations of inputs. This function is an assumed technological relationship,
based on the current state of engineering knowledge; it does not represent the result of economic
choices, but rather is an externally given entity that influences economic decision-making. Almost
all economic theories presuppose a production function, either on the firm level or the aggregate
level. In this sense, the production function is one of the key concepts
of mainstream neoclassical theories. Some non-mainstream economists, however, reject the very
concept of an aggregate production function

Aggregate production functions

In macroeconomics, aggregate production functions for whole nations are sometimes constructed.
In theory they are the summation of all the production functions of individual producers; however
there are methodological problems associated with aggregate production functions and economists
have debated extensively whether the concept is valid
A Production function can be represented in form of equation as:

Q= f ( L,N,k ….etc)

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Where Q stands for Quantity of output per unit of time and L, N, K, etc. are various factor inputs
like land, capital.

Factor inputs are of 2 types :-

Fixed inputs: are those factors, the quantity of which remains constant irrespective of the output
level of firm e.g. land, machines, buildings etc.

Variable inputs : are those factors, quantity of which varies with variation in levels of output
produced by the firm e.g. raw materials, power, fuel etc.

It is important to understand that Production function is assumed to be continuous function. i.e.

any change in input variable factors will produce corresponding changes in output. There are 2
types of production function.

Short run Production function :

Quantities of all inputs both fixed and variable will be kept constant and only one variable input will
be varied. E.g. Law of Variable Proportions

Quantities of all inputs both fixed and variable will be kept constant and only two variable input will
be varied. E.g. Iso quants and Iso cost curves.

Long run Production function:

In this case the producer will vary the quantities of all factor inputs, both fixed as well as
variable in same proportion as in case of the laws of returns to scale . If there are any
improvements in state of technology, managerial ability, organizational skills of a firm, then the
old Production function is disturbed and a new one takes its place. This can be done by
reducing the input quantity while output remains the same or by increasing the output quantity
keeping the input quantity of same or output quantity may increase and input quantity may
decrease.

USE OF PRODUCTION FUNCTION IN BUSINESS

Though Production function may appear as highly abstract, it is both logical and useful for
managers and executives in the decision making process at the firm level.

There are several possible combinations of inputs and decision makers have to choose the
most appropriate among them. The following are some of the important uses of Production
function:

 It can be used to calculate or work out the least cost input combination for a given output or
the maximum output-input combination for a given cost.

 It is useful in working out an optimum and economic combination of inputs for getting a
certain level of output. With the help of Production function the utility of employing a unit
of variable factor input in the production process can be judged. We would employ an

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additional variable factor input if marginal revenue productivity of that variable factor input
is greater than or equal to cost of employing it in the firm.

 Production function also helps in making long run decisions. If returns to scale are
increasing, it would be smart enough to employ more factor units and increase production.
On the other hand if returns to scale are diminishing it would be unwise to employ more
factor units and increase production. If there is constant returns to scale, managers will be
in a dilemma whether to increase or decrease production.

Thus the Production function helps both in the short run and long run decision-making
process. By assuming that the maximum output technologically possible from a given set of inputs
is achieved, economists using a production function in analysis are abstracting from the
engineering and managerial problems inherently associated with a particular production process.
The engineering and managerial problems of technical efficiency are assumed to be solved, so that
analysis can focus on the problems of allocative efficiency. The firm is assumed to be making
allocative choices concerning how much of each input factor to use and how much output to
produce, given the cost (purchase price) of each factor, the selling price of the output, and the
technological determinants represented by the production function. A decision frame in which one
or more inputs are held constant may be used; for example, capital may be assumed to be fixed
(constant) in the short run, and labour and possibly other inputs such as raw materials variable,
while in the long run, the quantities of both capital and the other factors that may be chosen by the
firm are variable. In the long run, the firm may even have a choice of technologies, represented by
various possible production functions.

The relationship of output to inputs is non-monetary; that is, a production function relates
physical inputs to physical outputs, and prices and costs are reflected in the function. But the
production function is not a full model of the production process: it deliberately abstracts from
inherent aspects of physical production processes that some would argue are essential, including
error, entropy or waste. Moreover, production functions do not ordinarily model the business
processes, either, ignoring the role of management.

The primary purpose of the production function is to address allocative efficiency in the use
of factor inputs in production and the resulting distribution of income to those factors. Under
certain assumptions, the production function can be used to derive a marginal product for each
factor, which implies an ideal division of the income generated from output into an income due to
each input factor of production.

Question No.4 : How do external and internal economies affect returns to scale?

Answer

Internal and External Economies of Scale

Alfred Marshall made a distinction between internal and external economies of scale. When a
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company reduces costs and increases production, internal economies of scale have been achieved.
External economies of scale occur outside of a firm, within an industry. Thus, when an industry's
scope of operations expands due to, for example, the creation of a better transportation network,
resulting in a subsequent decrease in cost for a company working within that industry, external
economies of scale are said to have been achieved. With external ES, all firms within the industry
will benefit. The advantages or benefits that accrue to a firm as a result of increase in its scale of
production are called ‛Economies of scale’. There are of two types of Economies viz. Internal
Economies and External Economies.

External Economies: are those economies which accrue to the firms as a result of the expansion
in output of whole industry and not dependent on output level of a single firm. External Economies
can return to scale in the following manner:

 By agglomeration : by concentrating group of industries in one particular area , all the

members of the group industry can enjoy the benefits of cheap labor, trained labor, water
and power supply requirements, transport and maintenance services etc thus reducing the
cost of operation of each individual firm.
 Through information technology and by localization of industries in a particular region can
help in idea sharing, discussion on common organizational barriers readily available for all
the firms which indirectly will economize the expenditure of single firm.
 By disintegrating economy into smaller units or newer units can enhance working efficiency
of the firms and cut down unit costs.
 By active support and assistance given by government such as tax concessions, tax
exemptions, subsidies can improve financial conditions of the firm.
 Certain economies can be benefitted in terms of better productivity and low absenteeism by
environmental factors like good climate, weather conditions, and soil fertility.
 Big industries can get lands at concessional rates and procure special facilities from local
government to set up health care units, training centers and educational institutions which
lead to improve the overall efficiency and productivity of workers.

Internal Economies: are those economies which arise because of the actions of an individual firm
to economize its cost. They arise due to increase in the scale of output of a firm and complete
utilization of indivisible factor inputs. Internal Economies can return to scale in the following
manner:

 In Technical Economies: by using latest and improved manufacturing techniques, it can

reduce the cost. Also by increasing the dimension of a firm it can avoid time wastage
and can reduce company cost. By mutual understanding between different firms to work
together such as dairy farming, can derive benefits of linked processes. Also by
adequate funding for R &D in between firms can help in improved quality of products
and profit making as well. By utilizing latest material management techniques like Just in
Time a firm can save lot of money in inventory management.
 In Managerial Economies: By delegating powers to specialized personnel in all
departments of the organization, can enable the Manager to bring improvements in
production process and bringing down the cost of production.
 In Marketing Economies: A large firm can buy raw materials and other inputs at
concessional rates compared to smaller firms, thus cutting cost. Also it can push the
products aggressively by a team of experts to improve the efficiency of firm.
 In financial Economies: Large firms because of its name can mobilize huge funds from
money market, capital market at concessional interest rates and can borrow from banks
at cheaper rates. Also suppliers are willing to supply material at comparatively lower
rates.

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 In Labor economies by employing talented persons, by adequate training facilities inside

the campus and providing recreational facilities can raise the average productivity of
worker and reduce the cost per unit output.
 Large companies by providing their own fleet of transport and storage facilities can
reduce operation costs. Also overhead costs will be reduced in large economies.

As firms become larger and their scale of operations increase they are able to experience
reductions in their average costs of production. The firm is said to be experiencing increasing
returns to scale. Increasing returns to scale results in the firm's output increasing at a greater
proportion than its inputs and hence its total costs. As a consequence its average costs fall.

Thus initially the firm's long run average cost curve slopes downward as the scale of the enterprise
expands. The firm enjoys benefits called internal economies of scale. These are cost reductions
accruing to the firm as a result of the growth of the firm itself. (An external economy of scale is a
benefit that the firms experience as a result of the growth of the industry.)

After the firm has reached its optimum scale of output, where the long run average cost curves are
at their lowest point, continued expansion means that its average costs may start to rise as the
firm now experiences decreasing returns to scale. The long run average cost curve therefore starts
to curve upwards. This occurs because the firm is now experiencing internal diseconomies of scale.

Returns to scale and costs in the long run

The table below shows a numerical example of how changes in the scale of production can, if
increasing returns to scale are exploited, lead to lower long run average costs.

Question No.5 : Discuss the profit maximization model.

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Answer

Profit Maximization Model and Theory for Market

Profit maximization is the rational behaviour of equilibrium assumption. Any firm which
aiming at profit maximization model; will go increasing its output till it reaches maximum profit
output. Profit is known nothing but differences between total revenue and total cost. The more the
differences between total revenue and total cost will create maximum profit. So, the equilibrium for
a firm will be when there is maximum difference between the total cost and total revenue.

The economic definition of profit is the difference between revenue and the opportunity
cost of all resources used to produce the items sold. This definition includes implicit returns as
costs. Because profit is a surplus in this definition, it should not persist in industries in which entry
is easy. Whenever a surplus exists, new firms should flow into an industry, bidding up the price of
resources and bidding down the price of output until profit in the economic definition is eliminated.
Profit should not exist in long-run equilibrium.

The Profit-Maximizing Output

Once a minimum total cost curve is determined, the marginal cost curve can be found from it.
Marginal cost is the additional cost of producing one more unit of output or the change in cost
divided by the change in output. This should not be confused with average cost, which is total cost
divided by total output. Marginal cost plays a leading role in the economist's story of the firm;
average cost plays a bit part.

The Profit-Maximizing Level of an Input

The determination of the profit-maximizing level of an input is, like the determination of the profit-
maximizing level of output, a mathematical problem if there is perfect knowledge of the supply
curves of resources, the production function, and the demand curve. It is another application of the
maximization principle, which says that the best level of an input is that level for which its marginal
benefit to the firm--the extra money the firm can obtain by hiring or buying the input--just equals
the marginal cost to the firm of hiring or buying the input. In the jargon of economists,
the marginal revenue product of an input should equal the marginal resource cost.

 Economist Theory of Firm:

According to the Economist Theory of Firm, a firm is a transformation unit, which converts
input into output and while doing so, tries to create surplus value. This surplus value is nothing but
the difference between the value of the product and the value of the factors of production. The firm
aiming for profit maximization reaches its equilibrium only when it produces profit maximizing
output. The firm maximizes profit by equating marginal revenue with marginal cost.

 Behavioral Theory of Cyert & March:

According to the theory, in a large multi-product firm the management is not the owner. There are
forms of business firm which compromises the group of individuals and not controlled by single
entity.

 Marris Growth Maximization Model:

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Robin Marris is the developer of the model. According to this theory, modern firms are managed by
both the manager and the shareholders. A manager aims to maximize the rate of growth of the
firm and the shareholders will try to maximize the dividend and the increase the share price.

 Sales Maximization Model:

This is alternative model for profit maximization model. The model has been propounded by W.J.
Baumol who was an American Economist. The assumption in this theory is relation about business
behavior. Baumol thinks managers are more interested in maximizing sales rather than profit.

 Williamson’s Managerial Discretionary Theory:

According to the theory, in a firm, shareholders and managers are two separate groups. The firm
tries to get maximum returns on investment and get maximum profit, whereas managers try to
maximize profit in their satisfying function.

At last, Williamson’s managerial discretion theory shows the utility function of a manager. In this
theory, the firm will try to get maximum returns or maximum profit where as manager try to
maximum utility satisfying function. They are in equilibrium when the utility has maximum amount.

The main propositions of the model are:

 A firm is a producing unit and as such it converts various inputs into outputs of higher value
under a given production technique.

 Maximizing profit is the basic objective of each firm

 A firm operates under a given market condition.

 A firm will choose the best alternative way to yield more profit.

 A firm makes an attempt to change its price, input and output quantity to maximize profit.

In order for a firm to maximize its profits it has to take into account the following:

 Pricing and business strategies, aggressive sales promotion policies of rival firms and its
impact on working of the given firm.

 Maintaining quality of products and service to customers

 Shouldn’t induce workers for higher wages demand which will lead to higher operation
costs.

 Adopting a stable business policy maintaining its reputation, name, fame and image in the
market. Taking various kinds of risks and uncertainties in changing business environment
and without resorting to monopolistic and exploitative practices.

Some conflicts in Profit maximization model are:

• It cannot always be possible for profit maximization, so company has to look into other
aspects such as market share expansion, building name, fame etc.

• In present day organizations ownership and management is separated and some salaried
managers have their self interests and focus on Profit maximization is not possible.

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• Sometimes due to lack of information, right decisions cannot be taken at right time so Profit
maximization cannot be realized.

• Due to conflicts in inter departmental levels, Profit maximization cannot be achieved.

• In context of highly competitive and changing business environment, consumers taste and
requirements cannot be met and as such profits cannot be maximized.

• In developing countries like India, public corporations are not legalized to make profits.

• Higher quality of production, customer satisfaction can lead to reduction in Profit

maximization

Question No.6: Examine the relationship between revenue concepts and price elasticity of
demand.

Answer

RELATIONSHIP - PRICE ELASTICITY AND REVENUE CONCEPT

The demand curve is a tremendously useful illustration. The downward slope tells us that there is
an inverse relationship between price and quantity. Also the demand curve as separating a
region in which sellers can operate from a region forbidden to them. But there is more, especially
when one considers what an area on the graph represents.

If people will buy 100 units of a product when its price is $10.00, as the picture below illustrates,
total revenue for sellers will be $1000. Simple geometry tells us that the area of the rectangle
formed under the demand curve in the picture is found by multiplying the height of the rectangle
by its width. Because the height is price and the width is quantity, and since price multiplied by
quantity is total revenue, the area is total revenue. The fact that area on supply and demand
graphs measures total revenue (or total expenditure by buyers, which is the same thing from
another viewpoint) is a key idea used repeatedly in microeconomics.

From the demand curve, we can obtain total revenue. From total revenue, we can obtain another
key concept: marginal revenue. Marginal revenue is the additional revenue added by an
additional unit of output, or in terms of a formula:

Marginal Revenue = (Change in total revenue) divided by (Change in sales)

According to the picture, people will not buy more than 100 units at a price of $10.00. To sell more,
price must drop. Suppose that to sell the 101st unit, the price must drop to $9.95. What will the
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marginal revenue of the 101st unit be? Or, in other words, by how much will total revenue increase
when the 101st unit is sold?

There is a temptation to answer this question by replying, "$9.95." A little arithmetic shows that
this answer is incorrect. Total revenue when 100 are sold is $1000. When 101 are sold, total
revenue is (101) x ($9.95) = $1004.95. The marginal revenue of the 101st unit is only $4.95.

To see why the marginal revenue is less than price, one must understand the importance of the
downward-sloping demand curve. To sell another unit, sellers must lower price on all units. They
received an extra $9.95 for the 101st unit, but they lost $.05 on the 100 that they were previously
selling. So the net increase in revenue was the $9.95 minus the $5.00, or $4.95.There is a way to
see why marginal revenue will be less than price when a demand curve slopes downward. Price is
average revenue. If the firm sells 100 for $10.00, the average revenue for each unit is $10.00. But
as sellers sell more, the average revenue (or price) drops, and this can only happen if the marginal
revenue is below price, pulling the average down.

If one knows marginal revenue, one can tell what happens to total revenue if sales change. If
selling another unit increases total revenue, the marginal revenue must be greater than zero. If
marginal revenue is less than zero, then selling another unit takes away from total revenue. If
marginal revenue is zero, than selling another does not change total revenue. This relationship
exists because marginal revenue measures the slope of the total revenue curve.

The picture above illustrates the relationship between total revenue and marginal revenue. The
total revenue curve will be zero when nothing is sold and zero again when a great deal is sold at a
zero price. Thus, it has the shape of an inverted U. The slope of any curve is defined as the rise
over the run. The rise for the total revenue curve is the change in total revenue, and the run is the
change in output. Therefore,

Slope of Total Revenue Curve = (Change in total revenue) / (Change in amount sold), But this
definition of slope is identical to the definition of marginal revenue, which
demonstrates that marginal revenue is the slope of the total revenue curve

From Elasticity to Marginal Revenue

Marginal revenue is the extra revenue from adding another unit of output. If a firm finds that when
it sells six units, its revenue is 24, and when it sells eight, its revenue is 28, its extra revenue for
adding two more units is four. Its marginal revenue, or the extra revenue for adding one more unit
of production, will be two.

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The graph above illustrates an alternative way to compute this extra revenue. When the firm sells
six, it can charge a price of $4, but when it sells eight, it can charge only $3.50. (Thus, six units at
$4 each give total revenue of $24 and eight units at $3.50 each give total revenue of $28.) When
the firm sells the extra two units, it adds two units at $3.50 each, or $7 to its revenue. However, it
also loses something because it had to lower the price on the six units it was previously selling. The
loss is these six units times $.5 each, or $3. The net change in revenue is $7 less $3, or $4.
Equation says that to get marginal revenue, the change in total revenue ($4) must be divided by
the change in output (2), which in this example gives us $2.

Marginal revenue can be computed as, (Change in Q)P + (Change in P)Q) divided by (Change in
Q). When changes in price and quantity are very, very small, the formula for price elasticity can be
written as

e = ((Change in Q)/Q) divided by ((Change in P)/P) . These two formulas to show that the following
equation is true: Marginal Revenue = Price (1 - 1/|elasticity|)

This last formula says that if demand is inelastic (less than one), trying to sell more will reduce
total revenue, whereas if demand is elastic (greater than one), trying to sell more will increase total
revenue. This should make intuitive sense. If people are not sensitive to price, then one must
reduce price a great deal to sell more, which means that total revenue declines.

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