{"id":5952,"date":"2016-07-19T18:00:35","date_gmt":"2016-07-19T18:00:35","guid":{"rendered":"https:\/\/courses.lumenlearning.com\/macroeconomics\/?post_type=chapter&p=5952"},"modified":"2016-07-19T18:00:35","modified_gmt":"2016-07-19T18:00:35","slug":"reading-elasticity-and-total-revenue","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/suny-hccc-macroeconomics\/chapter\/reading-elasticity-and-total-revenue\/","title":{"raw":"Reading: Elasticity and Total Revenue","rendered":"Reading: Elasticity and Total Revenue"},"content":{"raw":"

Total Revenue and Elasticity of Demand<\/h2>\nStudying elasticities is useful for a number of reasons, pricing being the most important. The key consideration\u00a0when thinking about maximizing\u00a0revenue is the price elasticity of demand. Total revenue<\/strong> is the price of an item multiplied by the number of units\u00a0sold: TR = P x Qd. When\u00a0a firm considers a price increase or decrease, there are\u00a0three possibilities, which are laid out in Table 1, below.\n\nTable 1. Price Elasticity of Demand\n
If demand is . . .<\/strong><\/td>\nThen . . .<\/strong><\/td>\nTherefore . . .<\/strong><\/td>\n<\/tr>
Elastic<\/td>\n% change in Qd is greater than\u00a0% change in P<\/td>\nA given % rise in P will be more than offset by a larger % fall in Q so that total revenue (P times\u00a0Q) falls.<\/td>\n<\/tr>
Unitary<\/td>\n% change in Qd is equal to % change in P<\/td>\nA given % rise in P will be exactly offset by an equal % fall in Q so that total revenue (P times Q) is unchanged.<\/td>\n<\/tr>
Inelastic<\/td>\n% change in Qd is less than % change in P<\/td>\nA given % rise in P will cause a smaller % fall in Q so that total revenue (P times Q) rises.<\/td>\n<\/tr><\/tbody><\/table>\nIf demand is elastic at a given\u00a0price level, then the company\u00a0should cut its price, because the percentage drop in price will result in an even larger percentage increase in the quantity sold\u2014thus raising total revenue. However, if demand is inelastic at the original quantity level, then the company\u00a0should raise its\u00a0prices, because the\u00a0percentage increase in price will result in a smaller percentage decrease in the quantity sold\u2014and total revenue will rise.\n\nLet's explore some specific examples.\u00a0In both cases we\u00a0will\u00a0answer the following questions:\n
  1. How much\u00a0of an impact do we think\u00a0a price change will have on demand?<\/li>\n\t
  2. How would we calculate the elasticity, and does it confirm our assumption?<\/li>\n\t
  3. What impact does the elasticity have on total revenue?<\/li>\n<\/ol>

    Example 1: The Student Parking Permit<\/h2>\n\"Cars<\/a>\n\nHow elastic is the demand for student parking passes at your institution? The answer to that question likely varies based on the profile of your institution, but we are going to explore a particular example.\u00a0Let's consider a community college campus where all of the students commute to class. Required courses are spread throughout the day and the evening, and most of the classes require classroom attendance (rather than online participation). There is a reasonable public transportation system with busses coming to and leaving campus from several lines, but the majority of students drive to campus. A student parking permit costs $40 per term. As the parking lots become\u00a0increasingly congested, the college considers raising the price of the parking passes in hopes that it will encourage more students to carpool or to take the bus.\n\nIf the college increases the price of a parking permit from $40 to $48, will fewer students buy parking permits?\n\nIf you think\u00a0that the change in price will cause many students to decide not to buy a permit, then you are suggesting that the demand is elastic\u2014the students are quite sensitive to price changes. If you think\u00a0that the change in price will not impact student permit purchases much, then you are suggesting that the demand is inelastic\u2014student\u00a0demand for permits is\u00a0insensitive to price changes.\n\nIn this case, we can all argue that students are very sensitive to increases in costs in general<\/em>, but the determining factor in their demand for parking permits is more likely to be the quality of alternative solutions. If the bus service does not allow students to travel between home, school, and work in a reasonable amount of time, many students will resort\u00a0to buying a parking permit, even at the higher price. Because students don't generally have extra money, they may grumble about a price increase, but many will still have to pay.\n\nLet's add some numbers and test our thinking. The college implements the proposed increase of $8, taking the new price to $48.\u00a0Last year the college sold 12,800 student parking passes. This year, at the new price, the college sells 11,520 parking passes.\u00a0<\/span>\n

    [latex]\\displaystyle\\text{percent change in quantity}=\\frac{11,520-12,800}{(11,520+12,800)\\div{2}}\\times{100}=\\frac{-1280}{12160}\\times{100}=-10.53[\/latex]<\/p>\n

    [latex]\\displaystyle\\text{percent change in price}=\\frac{48-40}{(48+40)\\div{2}}\\times{100}=\\frac{8}{44}\\times{100}=18.18[\/latex]<\/p>\n

    [latex]\\displaystyle\\text{Price Elasticity of Demand}=\\frac{-10.53\\text{ percent}}{18.18\\text{ percent}}=-.58[\/latex]<\/p>\nFirst, looking only at the percent change in quantity and the percent change in price we know\u00a0that an 18% change in price will resulted in an 11% change in demand. In other words, a large change in price created a compar<\/span>atively smaller change in demand. We can also see that the elasticity is 0.58. When the absolute value of the price elasticity is < 1, the demand\u00a0is inelastic. In this example, student demand for parking permits is inelastic.\n\nWhat impact does the price change have on the college and their goals for students? First, there are 1,280 fewer cars taking up\u00a0parking places. If all of those students are using alternative transportation to get to school and this change has relieved parking-capacity issues, then the college may\u00a0have achieved its goals. However, there's more to the story: the price change also has an effect on the college's revenue, as we can see below:\n

    Year 1: 12,800 parking permits sold x $40 per permit = $512,000<\/p>\n

    Year 2: 11,520 parking permits sold x $48 per permit = $552,960<\/p>\nThe college earned an additional $40,960 in revenue. Perhaps this can be used to expand parking or address other student transportation issues.\n\nIn this case, student demand for parking permits is inelastic. A significant change in price leads to a comparatively smaller change in demand. The result is lower sales of parking passes but more revenue.\n\nNote: If you attend an institution that offers courses completely or largely online, the price elasticity for parking permits might\u00a0be perfectly inelastic. Even if the institution gave away\u00a0parking permits, students might\u00a0not want them.\n

    Example 2: Helen's Cookies<\/h2>\n\"A<\/a>\n\nHave you been at the counter of a convenience store and seen cookies for sale on the counter? In this example we are going to consider a baker, Helen, who bakes these cookies and sells them $2 each. The cookies are sold in a convenience store, which has several options on the counter that customers can choose as a last-minute impulse buy.\u00a0All of the impulse items range between $1 and $2 in price. In order to raise revenue, Helen decides to raise her price to $2.20.\n\nIf Helen\u00a0increases the cookie price from $2.00 to $2.20\u2014a 10% increase\u2014will fewer customers buy cookies?\n\nIf you think\u00a0that the change in price will cause many buyers to forego a cookie, then\u00a0you are suggesting that the demand is elastic, or that the buyers\u00a0are sensitive to price changes. If you think\u00a0that the change in price will not impact sales much, then you are suggesting that the demand for cookies\u00a0is inelastic, or insensitive to price changes.\n\nLet's assume that this price change does impact customer behavior. Many customers choose a $1 chocolate bar or a $1.50 doughnut over the cookie, or they simply resist the temptation of the cookie at the higher price. Before we do any math, this assumption suggests that the demand for cookies is elastic.\n\nAdding in the numbers, we find that Helen's\u00a0weekly sales drop from 200 cookies to 150 cookies. This is a 25% change in demand on account of\u00a0a 10% price increase. We immediately see that the change in demand is greater than the change in price. That means that demand is elastic. Let's do the math.\n

    [latex]\\displaystyle\\text{percent change in quantity}=\\frac{150-200}{(150+200)\\div{2}}\\times{100}=\\frac{-50}{175}\\times{100}=-28.75[\/latex]<\/p>\n

    [latex]\\displaystyle\\text{percent change in price}=\\frac{2.20-2.00}{(2.00+2.20)\\div{2}}\\times{100}=\\frac{.20}{2.10}\\times{100}=9.52[\/latex]<\/p>\n

    [latex]\\displaystyle\\text{Price Elasticity of Demand}=\\frac{-28.75\\text{ percent}}{9.52\\text{ percent}}=-3[\/latex]<\/p>\nWhen the absolute value of the price elasticity is > 1, the demand\u00a0is elastic. In this example, the demand for cookies\u00a0is elastic.\n\nWhat impact does this have on Helen's objective to increase revenue? It's not pretty.\n

    Price 1: 200 cookies sold x $2.00 per cookie = $400<\/p>\n

    Price 2: 150 cookies sold x $2.20 = $330<\/p>\nShe is earning less revenue because of the price change. What should Helen\u00a0do next? She has learned that a small change in price leads to a large change in demand. What if she lowered the price slightly from her original $2.00 price? If the pattern holds, then a small reduction in price will lead to a large increase in sales. That would give her\u00a0a much more favorable result.","rendered":"

    Total Revenue and Elasticity of Demand<\/h2>\n

    Studying elasticities is useful for a number of reasons, pricing being the most important. The key consideration\u00a0when thinking about maximizing\u00a0revenue is the price elasticity of demand. Total revenue<\/strong> is the price of an item multiplied by the number of units\u00a0sold: TR = P x Qd. When\u00a0a firm considers a price increase or decrease, there are\u00a0three possibilities, which are laid out in Table 1, below.<\/p>\n

    Table 1. Price Elasticity of Demand<\/p>\n\n\n\n\n\n\n
    If demand is . . .<\/strong><\/td>\nThen . . .<\/strong><\/td>\nTherefore . . .<\/strong><\/td>\n<\/tr>\n
    Elastic<\/td>\n% change in Qd is greater than\u00a0% change in P<\/td>\nA given % rise in P will be more than offset by a larger % fall in Q so that total revenue (P times\u00a0Q) falls.<\/td>\n<\/tr>\n
    Unitary<\/td>\n% change in Qd is equal to % change in P<\/td>\nA given % rise in P will be exactly offset by an equal % fall in Q so that total revenue (P times Q) is unchanged.<\/td>\n<\/tr>\n
    Inelastic<\/td>\n% change in Qd is less than % change in P<\/td>\nA given % rise in P will cause a smaller % fall in Q so that total revenue (P times Q) rises.<\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n

    If demand is elastic at a given\u00a0price level, then the company\u00a0should cut its price, because the percentage drop in price will result in an even larger percentage increase in the quantity sold\u2014thus raising total revenue. However, if demand is inelastic at the original quantity level, then the company\u00a0should raise its\u00a0prices, because the\u00a0percentage increase in price will result in a smaller percentage decrease in the quantity sold\u2014and total revenue will rise.<\/p>\n

    Let’s explore some specific examples.\u00a0In both cases we\u00a0will\u00a0answer the following questions:<\/p>\n

      \n
    1. How much\u00a0of an impact do we think\u00a0a price change will have on demand?<\/li>\n
    2. How would we calculate the elasticity, and does it confirm our assumption?<\/li>\n
    3. What impact does the elasticity have on total revenue?<\/li>\n<\/ol>\n

      Example 1: The Student Parking Permit<\/h2>\n

      \"Cars<\/a><\/p>\n

      How elastic is the demand for student parking passes at your institution? The answer to that question likely varies based on the profile of your institution, but we are going to explore a particular example.\u00a0Let’s consider a community college campus where all of the students commute to class. Required courses are spread throughout the day and the evening, and most of the classes require classroom attendance (rather than online participation). There is a reasonable public transportation system with busses coming to and leaving campus from several lines, but the majority of students drive to campus. A student parking permit costs $40 per term. As the parking lots become\u00a0increasingly congested, the college considers raising the price of the parking passes in hopes that it will encourage more students to carpool or to take the bus.<\/p>\n

      If the college increases the price of a parking permit from $40 to $48, will fewer students buy parking permits?<\/p>\n

      If you think\u00a0that the change in price will cause many students to decide not to buy a permit, then you are suggesting that the demand is elastic\u2014the students are quite sensitive to price changes. If you think\u00a0that the change in price will not impact student permit purchases much, then you are suggesting that the demand is inelastic\u2014student\u00a0demand for permits is\u00a0insensitive to price changes.<\/p>\n

      In this case, we can all argue that students are very sensitive to increases in costs in general<\/em>, but the determining factor in their demand for parking permits is more likely to be the quality of alternative solutions. If the bus service does not allow students to travel between home, school, and work in a reasonable amount of time, many students will resort\u00a0to buying a parking permit, even at the higher price. Because students don’t generally have extra money, they may grumble about a price increase, but many will still have to pay.<\/p>\n

      Let’s add some numbers and test our thinking. The college implements the proposed increase of $8, taking the new price to $48.\u00a0Last year the college sold 12,800 student parking passes. This year, at the new price, the college sells 11,520 parking passes.\u00a0<\/span><\/p>\n

      [latex]\\displaystyle\\text{percent change in quantity}=\\frac{11,520-12,800}{(11,520+12,800)\\div{2}}\\times{100}=\\frac{-1280}{12160}\\times{100}=-10.53[\/latex]<\/p>\n

      [latex]\\displaystyle\\text{percent change in price}=\\frac{48-40}{(48+40)\\div{2}}\\times{100}=\\frac{8}{44}\\times{100}=18.18[\/latex]<\/p>\n

      [latex]\\displaystyle\\text{Price Elasticity of Demand}=\\frac{-10.53\\text{ percent}}{18.18\\text{ percent}}=-.58[\/latex]<\/p>\n

      First, looking only at the percent change in quantity and the percent change in price we know\u00a0that an 18% change in price will resulted in an 11% change in demand. In other words, a large change in price created a compar<\/span>atively smaller change in demand. We can also see that the elasticity is 0.58. When the absolute value of the price elasticity is < 1, the demand\u00a0is inelastic. In this example, student demand for parking permits is inelastic.<\/p>\n

      What impact does the price change have on the college and their goals for students? First, there are 1,280 fewer cars taking up\u00a0parking places. If all of those students are using alternative transportation to get to school and this change has relieved parking-capacity issues, then the college may\u00a0have achieved its goals. However, there’s more to the story: the price change also has an effect on the college’s revenue, as we can see below:<\/p>\n

      Year 1: 12,800 parking permits sold x $40 per permit = $512,000<\/p>\n

      Year 2: 11,520 parking permits sold x $48 per permit = $552,960<\/p>\n

      The college earned an additional $40,960 in revenue. Perhaps this can be used to expand parking or address other student transportation issues.<\/p>\n

      In this case, student demand for parking permits is inelastic. A significant change in price leads to a comparatively smaller change in demand. The result is lower sales of parking passes but more revenue.<\/p>\n

      Note: If you attend an institution that offers courses completely or largely online, the price elasticity for parking permits might\u00a0be perfectly inelastic. Even if the institution gave away\u00a0parking permits, students might\u00a0not want them.<\/p>\n

      Example 2: Helen’s Cookies<\/h2>\n

      \"A<\/a><\/p>\n

      Have you been at the counter of a convenience store and seen cookies for sale on the counter? In this example we are going to consider a baker, Helen, who bakes these cookies and sells them $2 each. The cookies are sold in a convenience store, which has several options on the counter that customers can choose as a last-minute impulse buy.\u00a0All of the impulse items range between $1 and $2 in price. In order to raise revenue, Helen decides to raise her price to $2.20.<\/p>\n

      If Helen\u00a0increases the cookie price from $2.00 to $2.20\u2014a 10% increase\u2014will fewer customers buy cookies?<\/p>\n

      If you think\u00a0that the change in price will cause many buyers to forego a cookie, then\u00a0you are suggesting that the demand is elastic, or that the buyers\u00a0are sensitive to price changes. If you think\u00a0that the change in price will not impact sales much, then you are suggesting that the demand for cookies\u00a0is inelastic, or insensitive to price changes.<\/p>\n

      Let’s assume that this price change does impact customer behavior. Many customers choose a $1 chocolate bar or a $1.50 doughnut over the cookie, or they simply resist the temptation of the cookie at the higher price. Before we do any math, this assumption suggests that the demand for cookies is elastic.<\/p>\n

      Adding in the numbers, we find that Helen’s\u00a0weekly sales drop from 200 cookies to 150 cookies. This is a 25% change in demand on account of\u00a0a 10% price increase. We immediately see that the change in demand is greater than the change in price. That means that demand is elastic. Let’s do the math.<\/p>\n

      [latex]\\displaystyle\\text{percent change in quantity}=\\frac{150-200}{(150+200)\\div{2}}\\times{100}=\\frac{-50}{175}\\times{100}=-28.75[\/latex]<\/p>\n

      [latex]\\displaystyle\\text{percent change in price}=\\frac{2.20-2.00}{(2.00+2.20)\\div{2}}\\times{100}=\\frac{.20}{2.10}\\times{100}=9.52[\/latex]<\/p>\n

      [latex]\\displaystyle\\text{Price Elasticity of Demand}=\\frac{-28.75\\text{ percent}}{9.52\\text{ percent}}=-3[\/latex]<\/p>\n

      When the absolute value of the price elasticity is > 1, the demand\u00a0is elastic. In this example, the demand for cookies\u00a0is elastic.<\/p>\n

      What impact does this have on Helen’s objective to increase revenue? It’s not pretty.<\/p>\n

      Price 1: 200 cookies sold x $2.00 per cookie = $400<\/p>\n

      Price 2: 150 cookies sold x $2.20 = $330<\/p>\n

      She is earning less revenue because of the price change. What should Helen\u00a0do next? She has learned that a small change in price leads to a large change in demand. What if she lowered the price slightly from her original $2.00 price? If the pattern holds, then a small reduction in price will lead to a large increase in sales. That would give her\u00a0a much more favorable result.<\/p>\n\n\t\t\t

      \n\t\t\t

      Candela Citations<\/h3>\n\t\t\t\t\t
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      CC licensed content, Original<\/div>