Question

If demand is inelastic, total revenue increases as price increases. If demand is elastic, total revenue decreases as price increases. In the case of supply, total revenue does not depend upon elasticity. Why?

Short answer

Total revenue does not depend on the elasticity of supply because it is primarily determined by the demand side of the market. While supply elasticity focuses on the relationship between price and quantity supplied by producers, total revenue is a function of price and quantity demanded. The impact on total revenue following a price change largely depends on consumers' sensitivity to price changes (demand elasticity) rather than how suppliers react to the price changes (supply elasticity). Supply and demand interact to determine the equilibrium price and quantity in a market, but the elasticity of supply has no direct impact on the calculation of total revenue.

Step-by-step solution

Define Elasticity of Demand

Elasticity of demand is a measure of how sensitive the quantity demanded of a good or service is to a change in its price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. If the elasticity is greater than 1, the demand is said to be elastic, meaning that a change in price leads to a proportionally larger change in quantity demanded. If the elasticity is less than 1, the demand is inelastic, and a change in price leads to a proportionally smaller change in quantity demanded.

Discuss the Relationship between Total Revenue and Price for Inelastic and Elastic Demand

Total revenue is the product of price and quantity demanded. For inelastic demand, an increase in price leads to a smaller decrease in quantity demanded, resulting in a net increase in total revenue. Conversely, for elastic demand, an increase in price leads to a larger decrease in quantity demanded, resulting in a net decrease in total revenue.

Define Elasticity of Supply

Similar to demand elasticity, the elasticity of supply is a measure of how sensitive the quantity supplied of a good or service is to a change in its price. It is calculated as the percentage change in quantity supplied divided by the percentage change in price. The higher the elasticity, the more responsive quantity supplied is to changes in price.

Explain Why Total Revenue Does Not Depend on Elasticity of Supply

Total revenue is a function of the price and quantity demanded, while elasticity of supply focuses on the relationship between price and the quantity supplied by producers. The main reason total revenue does not depend on supply elasticity is that total revenue is determined by the demand side of the market. Both inelastic and elastic demands can exist for a product, and the impact on total revenue following a price change largely depends on the consumers' sensitivity to price changes (demand elasticity), rather than how suppliers react to the price changes (supply elasticity). Supply and demand interact to determine the equilibrium price and quantity in a market, but the elasticity of supply has no direct impact on the calculation of total revenue.

Key concepts

Total Revenue

Understanding total revenue is crucial for businesses as it directly affects their profitability. Total revenue is calculated as the product of the price of a good or service and the quantity of it sold.
This means:

• Total Revenue = Price × Quantity Demanded

Changes in price and demand can lead to changes in the total revenue earned by a company.
Depending on whether demand is elastic or inelastic, price adjustments can either increase or decrease total revenue. It is important for firms to understand their product's demand elasticity to make informed pricing decisions.

Inelastic Demand

Inelastic demand occurs when a change in price results in a less than proportionate change in the quantity demanded. This means that consumers are not highly sensitive to price changes for these goods.
When demand is inelastic:

• Increasing the price leads to slightly lower quantity demanded
• Total revenue usually increases because the decrease in quantity is not significant enough to offset the price increase

Common examples of inelastic products include necessities like fuel and prescription medications.
Because consumers need these products regardless of price, demand remains relatively stable.

Elastic Demand

Elastic demand is observed when a small change in price results in a significant change in the quantity demanded. Products with elastic demand are typically non-essential items or those with easily available substitutes.
Key characteristics of elastic demand include:

• Price increases lead to a large decrease in the quantity demanded
• As a result, total revenue decreases because the higher price causes a substantial drop in sales

Understanding whether a product has elastic demand helps businesses make strategic decisions about pricing and advertising, as consumers are more price-sensitive for these products.

Elasticity of Supply

Elasticity of supply measures how the quantity supplied of a good responds to a change in its price. It is analogous to demand elasticity but focuses on the supplier's perspective.
Notable aspects of supply elasticity include:

• If supply is elastic, producers can quickly increase production for a small increase in price
• With inelastic supply, quantity supplied changes very little with price fluctuations

However, total revenue primarily depends on consumer demand, not on how suppliers react to price changes.
This is why elasticity of supply does not directly impact total revenue, as it is largely determined by the demand side of the market.