Question

Which of the following will result in an increase in total revenue? a. Price increases when demand is elastic. b. Price decreases when demand is elastic. c. Price increases when demand is unitary elastic. d. Price decreases when demand is inelastic.

Short answer

The correct answer is: b. Price decreases when demand is elastic. In this case, a decrease in price leads to a more significant increase in quantity demanded, which results in an increase in the total revenue.

Step-by-step solution

Understanding Elasticities

Price elasticity of demand is a measure of the sensitivity of quantity demanded to changes in price. It can be calculated using the formula: \[Price\:Elasticity\:of\:Demand = \frac{% \%\:Change\:in\:Quantity\:Demanded}{\%\:Change\:in\:Price}\] 1. Elastic demand: If the absolute price elasticity of demand is greater than 1, the demand is elastic, meaning that the quantity demanded is more sensitive to changes in price. In this case, an increase in price will result in a decrease in the total revenue, while a decrease in price will result in an increase in the total revenue. 2. Inelastic demand: If the absolute price elasticity of demand is less than 1, the demand is inelastic, meaning that the quantity demanded is less sensitive to changes in price. In this case, an increase in price will result in an increase in the total revenue, while a decrease in price will result in a decrease in the total revenue. 3. Unitary elastic demand: If the absolute price elasticity of demand is equal to 1, the demand is unitary elastic, meaning that the quantity demanded is equally sensitive to changes in price. In this case, the total revenue remains constant when the price changes.

Checking each scenario

a. Price increases when demand is elastic. In elastic demand, an increase in price leads to a more significant decrease in quantity demanded, which results in a decrease in the total revenue. b. Price decreases when demand is elastic. In elastic demand, a decrease in price leads to a more significant increase in quantity demanded, which results in an increase in the total revenue. c. Price increases when demand is unitary elastic. In unitary elastic demand, any change in price will not affect total revenue because the percentage change in quantity demanded is equal to the percentage change in price. d. Price decreases when demand is inelastic. In inelastic demand, a decrease in price results in a smaller increase in quantity demanded, which results in a decrease in the total revenue.

Selecting the correct answer

From the analysis of each scenario, we can conclude that the scenario which results in an increase in total revenue is "b. Price decreases when demand is elastic."

Key concepts

Elastic Demand

When we talk about elastic demand, we're referring to a situation where consumers are quite responsive to changes in the price of a product. This means that if the price changes, there will be a significant change in the quantity demanded.
For example, if a product price drops, customers will want to buy much more of it. Conversely, if the price goes up, many will stop buying it. This leads to some interesting outcomes for businesses.

Here's what you need to know about elastic demand:

• Elastic demand occurs when the absolute value of price elasticity of demand is greater than 1.
• If the price decreases, total revenue will increase as more people buy the product without hesitation.
• If the price increases, total revenue will fall because the decrease in quantity demanded is significant.

This concept is crucial for companies as it helps them to strategize pricing. Lowering prices might lead to higher sales and more revenue when the demand is elastic.

Inelastic Demand

Inelastic demand is a bit different. In this scenario, consumers are less sensitive to changes in price. If you change the price of a product, the quantity demanded doesn't change much in comparison.
For items that are necessities or have fewer substitutes, demand usually remains inelastic. This is because consumers need them regardless of price changes.

Key points about inelastic demand include:

• Price elasticity is less than 1 in absolute value, indicating that quantity changes are small compared to price changes.
• An increase in price will result in increased total revenue, as the quantity demanded won't drop drastically.
• Decreasing prices leads to lower total revenue because the quantity demanded will not rise enough to offset the price cut.

This understanding allows businesses to maintain or increase prices without fear of losing too many customers, especially if their product is something people really need.

Unitary Elastic Demand

Unitary elastic demand is an interesting middle ground. Here, the demand is exactly aligned with price changes, meaning that any percentage change in price will result in an equal percentage change in quantity demanded.
The unique characteristic of this demand type is its balance between price and quantity.

Here's what you need to understand about unitary elastic demand:

• The price elasticity of demand equals 1, showing that changes in price and quantity demanded are proportionate.
• Whether the price goes up or down, the total revenue won't change as the loss in revenue from reduced sales perfectly balances the extra gain from a higher price, and vice versa.
• This elasticity often occurs at a specific point on the demand curve, rather than across the whole curve.

Businesses encounter unitary elasticity in situations where changing prices does not provide an economic advantage in terms of revenue.