Question

How would the following changes in price affect total revenue? That is, would total revenue increase, decrease, or remain unchanged? a. Price falls and demand is inelastic. b. Price rises and demand is elastic. c. Price rises and supply is elastic. d. Price rises and supply is inelastic. e. Price rises and demand is inelastic. f. Price falls and demand is elastic. g. Price falls and demand is of unit elasticity.

Short answer

a. Decrease, b. Decrease, c. Cannot determine, d. Cannot determine, e. Increase, f. Increase, g. Unchanged.

Step-by-step solution

Understanding Elasticity Concepts

Elasticity refers to how much the quantity demanded or supplied responds to a change in price. When demand is inelastic, quantity demanded changes little with price changes. When demand is elastic, quantity demanded changes significantly with price changes. Unit elasticity means the percentage change in price results in an equal percentage change in quantity.

Analyzing Case a

a. If price falls and demand is inelastic, quantity demanded increases slightly. Since the increase in quantity demanded does not offset the decrease in price, total revenue decreases.

Analyzing Case b

b. If price rises and demand is elastic, quantity demanded falls substantially. The fall in demand is proportionally larger than the price increase, causing total revenue to decrease.

Analyzing Case c

c. If price rises and supply is elastic, quantity supplied increases significantly. This scenario does not directly affect total revenue, as the focus is on demand factors. Total revenue cannot be determined solely on supply elasticity.

Analyzing Case d

d. If price rises and supply is inelastic, quantity supplied changes very little. Similar to Case c, this scenario is supply-focused and does not directly affect total revenue from a demand perspective.

Analyzing Case e

e. If price rises and demand is inelastic, quantity demanded decreases slightly. The decrease in quantity is less than the proportional increase in price, thus total revenue increases.

Analyzing Case f

f. If price falls and demand is elastic, quantity demanded increases significantly. The increase in quantity demanded is proportionally larger than the decrease in price, leading to an increase in total revenue.

Analyzing Case g

g. If price falls and demand has unit elasticity, the percentage change in quantity demanded equals the percentage change in price. Therefore, total revenue remains unchanged.

Key concepts

Price Elasticity of Demand

The concept of "Price Elasticity of Demand" helps us understand how sensitive the quantity demanded of a good is to a change in its price. Imagine stretching a rubber band; the more it stretches, the more elastic it is. Similarly, if a small change in price leads to a big change in quantity demanded, demand is considered elastic.
Think of luxury items, which people can easily do without. A 10% increase in price might result in a much larger drop in the quantity demanded because people can simply choose not to buy them.
On the other hand, if a change in price results in a smaller change in quantity demanded, the demand is inelastic. Essentials like bread or medication fit this scenario since people still buy them regardless of price changes.

Price Elasticity of Supply

Just as with demand, supply can also be elastic or inelastic, showing how responsive producers are to price changes. Elastic supply occurs when producers can greatly increase production if the price rises. Think about how some seasonal goods can be quickly produced and supplied in greater quantities if prices spike.

• If prices of strawberries increase during summer, more farms might jump into producing them, thus supply is elastic.
• Conversely, inelastic supply happens when producers cannot adjust production swiftly, typically due to time constraints or limited resources.

For instance, if diamond prices rise, miners can't immediately increase production due to the time and effort required.

Total Revenue

"Total Revenue" is simply the total amount of money a firm earns from selling its goods or services, calculated as the price per unit multiplied by the number of units sold. It's crucial for businesses to understand how changes in price and demand affect total revenue.

• If demand is elastic, a decrease in price will usually boost total revenue because the larger quantity sold outweighs the lower price.
• Conversely, if demand is inelastic, an increase in price typically leads to higher total revenue since the quantity sold doesn't drop significantly enough to offset the higher price.

Unsurprisingly, measuring elasticity is key for businesses when deciding their pricing strategies to maximize profits.

Inelastic Demand

"Inelastic Demand" arises when the quantity demanded changes very little even when prices change noticeably. This typically occurs with basic necessity goods that people need regardless of price fluctuations, such as gasoline or basic food items.
For example, if gas prices increase, most people still have to fill their tanks to commute to work or school.
When considering total revenue, a price increase in inelastic demand situations results in higher revenue because the drop in sales volume is marginal compared to the gained price increase.
Thus, businesses selling such goods benefit from higher prices since the demand shifts very little.

Elastic Demand

The concept of "Elastic Demand" means that any price change causes a significant change in the quantity demanded. Such demand is typical for non-essential and luxury items, where consumers are sensitive to price changes because they can easily delay or forego the purchase.

• If a tech gadget's price drops, the significant increase in sales can significantly raise total revenue more than offsetting the lower price per gadget.
• On the other hand, if the price rises, consumers may quickly reduce quantity bought, decreasing total revenue.

Businesses must carefully consider pricing for such goods, as sales volume is highly sensitive to price alterations.