Question

Statement 1. A perfectly elastic demand curve has an elasticity of zero. Statement 2. When demand is elastic and price is raised, total revenue will fall. (LO1) a) Statement 1 is true, and statement 2 is false. b) Statement 2 is true, and statement 1 is false. c) Both statements are true. d) Both statements are false.

Short answer

b) Statement 2 is true, and statement 1 is false.

Step-by-step solution

Statement 1 Analysis

A perfectly elastic demand curve has an elasticity of zero. This statement is false because a perfectly elastic demand curve has an elasticity of infinity.

Statement 2 Analysis

When demand is elastic and the price is raised, total revenue will fall. This statement is true because when demand is elastic (elasticity > 1), any increase in price will cause a significant decrease in the quantity demanded, leading to a decrease in total revenue.

Choosing the Correct Option

After analyzing both statements, we can conclude that statement 1 is false and statement 2 is true. So the correct option is: b) Statement 2 is true, and statement 1 is false.

Key concepts

Price Elasticity of Demand

Imagine you are deciding between two chocolate bars, and the price of your favorite one goes up. If you're like most people, you may switch to the other bar if it's cheaper. This behavior is captured by the concept of price elasticity of demand, which measures how sensitive the quantity demanded of a good is to a change in its price. Mathematically, the price elasticity of demand is represented by the percentage change in quantity demanded divided by the percentage change in price, expressed as:
\[ Elasticity = \frac{\% \text{ Change in Quantity Demanded}}{\% \text{ Change in Price}} \].
This concept helps us understand how consumers might react to price changes. If the absolute value of elasticity is greater than one, the demand is considered elastic, meaning consumers respond greatly to price changes. Conversely, if it's less than one, the demand is inelastic, and there's a less significant response to price changes.

Total Revenue and Elasticity

Total revenue, the overall income a company receives from selling its products, can tell us a lot about consumer behavior and market conditions. It is calculated by multiplying the price of a good by the quantity sold:
\[ Total Revenue = Price \times Quantity \].
Now, the relationship between total revenue and elasticity is intriguing. When demand is elastic, raising the price can lead to a drop in total revenue. This happens because the decrease in quantity sold is proportionally greater than the increase in the price, leading to less overall income. However, when demand is inelastic, an increase in price typically boosts total revenue since the decrease in quantity demanded isn't enough to offset the higher price. It's important for businesses to understand this relationship to avoid pricing themselves out of the market and to maximize their profits.

Perfectly Elastic Demand

In an ideal and quite extreme scenario, the perfectly elastic demand curve represents a situation where consumers have complete flexibility and immediate alternatives for a good or service. Here, the demand curve is horizontal, reflecting that even the smallest price increase leads to an unlimited drop in the quantity demanded—consumers would just switch to a perfect substitute. Conversely, any price decrease doesn't necessarily cause an infinite increase in quantity demanded since other factors can limit consumption. This concept is theoretical and rarely observed in real markets, but it serves as a useful benchmark to understand the concept of elasticity. In reality, most products have substitutes to some extent, so perfectly elastic demand guides us in considering how close substitutes might influence consumers' purchasing decisions.