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Why does cutting a price sometimes raise revenue and sometimes lower it?

Explain the relationship between price elasticity of demand and total revenue, and apply it to pricing decisions

A focused answer to the H2 Economics learning outcome on PED and total revenue. Why a price change moves revenue differently for elastic and inelastic goods, and how firms use this to set prices.

Generated by Claude Opus 4.88 min answerUpdated 2026-06-06

Reviewed by: AI editorial process; not yet individually human-reviewed

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What this dot point is asking
The answer
Examples in context
Try this

What this dot point is asking

SEAB wants you to explain the relationship between the price elasticity of demand and a firm's total revenue, and to apply it to pricing decisions. The central insight is that a price change pulls revenue in two opposing directions, and which one wins depends entirely on elasticity.

The answer

Total revenue and the two opposing effects

Total revenue (TR) is price multiplied by quantity:

TR = P \times Q

When a firm cuts price, two things happen at once:

The price effect: each unit sells for less, which tends to lower revenue.
The quantity effect: more units are sold, which tends to raise revenue.

Whether total revenue rises or falls depends on which effect is larger, and that is exactly what elasticity measures.

The revenue rule

The logic is the comparison of percentage changes. If demand is elastic, the percentage change in quantity is larger than the percentage change in price, so the quantity effect wins. If demand is inelastic, the percentage change in quantity is smaller, so the price effect wins.

Revenue along a straight-line demand curve

On a linear demand curve, demand is elastic at high prices and inelastic at low prices, with unit elasticity at the midpoint. So as you lower price from the top, revenue rises (elastic region), peaks at the midpoint (unit elastic), and then falls (inelastic region). Plotting total revenue against quantity gives an inverted-U shape peaking at the unit-elastic point.

Worked example

A streaming service charges $\$ 12 $a month to$ 1{,}000{,}000 $subscribers. It is considering a cut to$ \ $10$ . It estimates two scenarios: (A) demand is elastic and subscribers rise to $1{,}300{,}000$ ; (B) demand is inelastic and subscribers rise to $1{,}050{,}000$ . Find the revenue effect in each.

Step 1: Baseline revenue

$TR = \$ 12 \times 1{,}000{,}000 = \ $12{,}000{,}000$ per month.

Step 2: Scenario A (elastic)

New revenue $= \$ 10 \times 1{,}300{,}000 = \ $13{,}000{,}000$ . Revenue rises by $\$ 1{,}000{,}000 $. The large quantity gain ($ +30% $) outweighs the price fall ($ -16.7%$), consistent with elastic demand: the price cut raises revenue.

Step 3: Scenario B (inelastic)

New revenue $= \$ 10 \times 1{,}050{,}000 = \ $10{,}500{,}000$ . Revenue falls by $\$ 1{,}500{,}000 $. The small quantity gain ($ +5% $) fails to offset the price fall ($ -16.7%$), consistent with inelastic demand: the price cut lowers revenue.

Step 4: Conclude

The same price cut helps revenue if demand is elastic and hurts it if demand is inelastic. The firm must estimate PED before changing price, and should also weigh costs, since revenue is not profit.

Examples in context

Example 1. Public transport fares. Because demand for bus and train travel is inelastic for most commuters, an operator (or regulator) raising fares increases total fare revenue even as ridership dips slightly. This is why fare rises are an effective revenue tool, though the equity impact on lower-income commuters is a separate concern.

Example 2. Peak and off-peak pricing. A cinema or airline faces inelastic demand at peak times and elastic demand off-peak. Raising peak prices and cutting off-peak prices increases revenue in both periods, which is the elasticity logic behind peak pricing and a form of price discrimination.

Try this

Q1. State what happens to total revenue when the price of an inelastic good is raised. [2 marks]

Cue. Total revenue rises, because quantity falls proportionately less than price rises, so the price effect dominates.

Q2. Explain why total revenue is maximised at unit elasticity. [3 marks]

Cue. Below unit elasticity (elastic), cutting price raises revenue; above it (inelastic), cutting price lowers revenue; so revenue peaks exactly where $|PED| = 1$ and the two effects offset.

Q3. A firm with an elastic product wants more revenue. What should it do, and why? [2 marks]

Cue. Cut the price: with elastic demand the percentage rise in quantity exceeds the percentage fall in price, so total revenue increases.

Exam-style practice questions

Practice questions written in the style of SEAB exam questions on this dot point, with worked answer explainers. The year tag is the paper they imitate, not the source.

Original8 marksExplain how the price elasticity of demand determines whether a price cut raises or lowers a firm's total revenue.

Show worked answer →

An 8 mark question rewards the revenue rule, the reasoning behind it, and the unit-elastic peak.

The rule: For an elastic good ( $|PED| > 1$ ), a price cut raises total revenue; for an inelastic good ( $|PED| < 1$ ), a price cut lowers it. Total revenue is maximised where demand is unit elastic.
Why for elastic goods: Total revenue is price times quantity. When demand is elastic, the percentage rise in quantity exceeds the percentage fall in price, so the quantity effect dominates and revenue rises.
Why for inelastic goods: When demand is inelastic, the percentage rise in quantity is smaller than the percentage fall in price, so the price effect dominates and revenue falls.

Markers reward the price-times-quantity definition, the comparison of the percentage changes, and the unit-elastic revenue maximum.

Original9 marksA firm sells a product with

PED = -0.5

. Analyse whether it should raise or lower price to increase revenue, and discuss what else it should consider.

Show worked answer →

A 9 mark question rewards a correct revenue decision plus evaluation of profit and other factors.

Revenue decision: With $PED = -0.5$ , demand is inelastic. A price rise reduces quantity proportionately less than the price increase, so total revenue rises. To raise revenue, the firm should raise price.
But revenue is not profit: A price rise that cuts quantity also cuts variable costs, so profit may rise by more than revenue. The firm should compare the change in revenue with the change in cost.
Other considerations: Competitor reactions, the risk of attracting entry, consumer goodwill, and whether the inelasticity holds over the relevant range and time horizon all matter; demand may become more elastic in the long run.

Markers reward the inelastic-so-raise-price conclusion, the distinction between revenue and profit, and at least two evaluative considerations.