With an appropriate illustration, explain the circumstance in which an increase in output of a producer would (a) decrease his sales revenue [10 marks] (b) ...

Answer Details

When a producer sells more, the extra output can only be sold at a lower price, so he moves down his demand curve. Whether total sales revenue \( (R = P \times Q) \) rises or falls depends on the price elasticity of demand for the product, that is, on how strongly quantity demanded responds to the price change.

(a) When an increase in output decreases sales revenue. This happens when demand is price-inelastic \( (E_d < 1) \). Here a fall in price brings only a smaller proportionate rise in quantity demanded. Because price falls by more (in proportion) than quantity rises, the loss from the lower price outweighs the gain from the extra sales, so total revenue falls. For example, if raising output forces price down by 20% but quantity sold rises by only 5%, revenue drops. This is typical of necessities such as staple foodstuffs.

(b) When an increase in output increases sales revenue. This happens when demand is price-elastic \( (E_d > 1) \). Here a fall in price brings a larger proportionate rise in quantity demanded. The gain from the many extra units more than makes up for the lower price on each unit, so total revenue rises. For example, if price falls by 5% but quantity sold rises by 20%, revenue increases. This is typical of luxuries and goods with close substitutes.

On a diagram, revenue is the rectangle \( P \times Q \) under the demand curve. On a steep (inelastic) demand curve the rectangle shrinks as we move down; on a flat (elastic) demand curve it grows.

Examination takeaway: tie the direction of the revenue change to elasticity, revenue and price move together when demand is inelastic, and revenue and price move in opposite directions (revenue rises as output rises) when demand is elastic.