Suppose that, in an attempt to raise more revenue, Nobody State University increases its tuition. Will this necessarily result in more revenue?
Not necessarily. As we know, revenue depends on price and quantity of a given good or service; in the case of Nobody State,
Revenue = Tuition Price x Number of Enrolled Students
If tuition price increases, the number of students will likely fall as fewer students will be able to afford Nobody State and will favor its nearby competitor, Anybody Community College. As we can see, the qualitative aspect of demand is easy to grasp (increase prices, lower demand) but the quantitative side can be tricky. As posited by Mankiw (2012), we “discussed the direction in which quantity demanded moves but not the size of the change. To measure how much consumers respond to changes in these variables, economists use the concept of elasticity” (Mankiw, 2012, p. 90).
If we suggest that a 10% increase in tuition will lower student enrollment by 20%, the impact on revenue would be: 110% x 80% = 88% or a 12% decrease in total revenue, despite the increase in tuition. Following the Mankiw (2012) definition of elasticity, at a 10% increase in tuition for Nobody State Univeristy, the price demand elasticity is negative: the decrease in enrolled students will be more significant than the tuition increase.
Under what conditions will revenue (a) rise, (b) fall, or (c) remain the same? Explain this process, focusing on the relationship between the increased revenue from students enrolling at NSU despite the higher tuition and the lost revenue from possible lower enrollment.
The proper formula for the price elasticity of demand is shown by Acemoglu, Laibson, & List (2016, p. 132):
In our example, (-20%)/(10%) = - 2.0. That is the price elasticity of demand – for every one percent of a tuition increase in NSU, there would be a two percent decrease in the amount of students enrolled.
In this case, the price elasticity is negative – as it should be, since tuition prices follow the Law of Demand – and is greater than one: if tuitions were raised by 5%, the price elasticity of demand of -2.0 would indicate a number of enrolled students decrease by 10%. In this case, we say that demand is elastic: “the percentage change in quantity demanded is greater than the percentage change in price” Acemoglu, Laibson, & List (2016, p. 134). Hence, lost revenue from lower enrollment more than offsets the effects of higher tuition rates. Under the conditions of an elastic demand (elasticity > 1), NSU revenues fall after a price increase.
Acemoglu, Laibson, & List (2016) also indicate that demand can be unit elastic (elasticity = 1) (p. 134). In such cases, a price increase does not affect total expenditures on the good. Were the NSU price elasticity of demand unit elastic, its revenues would remain the same despite a tuition increase.
Finally, we could have inelastic demand (elasticity < 1), where the tuition increase of NSU would more than offset the drop in enrollment and revenues would increase.
If the true price elasticity were -1.2, what would you suggest the university do to expand revenue?
Using the definition of Acemoglu, Laibson, & List (2016), a price elasticity of -1.2 indicates an elastic demand, where NSU revenues fall after a price increase.
For example, if NSU tuition increased by 3%, the enrollment would decrease by 3.6%. New revenue = 103% x 96.4% = 99.29% of original revenue, or a 0.71% decrease in revenues.
Now, since we know that the demand is elastic, we are aware that if tuition decreases, the number of enrolled students will increase. For example, let us suggest a 5% decrease in tuition. Since price elasticity of demand is -1.2, enrollment would increase by 6%.
New revenue = 95% x 106% = 100.7% of original revenue.
Therefore, a 5% decrease in tuition would mean a 0.7% increase in NSU revenue, due to the price elasticity of demand. Although this result may offend common sense, the numbers are correct and in accordance with good economic theory – this is just one of the offshoots of the Law of Demand.
If you were the president of NSU, how would you tackle this problem based on what you have learned in this course?
If I were the President of NSU, I would address its revenue problem by slightly decreasing tuition costs. Because of the estimated price elasticity of -1.2, I would know that price decreases would lead to an increase in total revenue.
But why a slight decrease in tuition? One may ask, ‘since demand is price elastic at -1.2, why not decrease tuition by 80% and watch a 106% increase in enrollment?’ The answer to this statement is negative because the price elasticity of demand changes at different price levels. Only so many students will want to enroll at NSU – be it because some will always prefer Anybody Community over NSU, or because there are not enough high school graduates in the area, the reasons are of no importance. The fact is that at much lower price levels – such as the 80% drop described – demand for NSU has reached its inelastic levels, where price drops will not matter as much, and the increase in enrollment will not offset the tuition decrease.
Therefore, were I the president of NSU, I would slightly reduce tuition every year until we reached unit elasticity and no further benefit could be extracted from this policy.
References
Acemoglu, D., Laibson, D. I., & List, J. A. (2016). Microeconomics. Boston, Mass.: Pearson
Mankiw, N. G. (2012). Essentials of Economics. Mason, OH: South-Western Cengage
Learning.