CFA Practice Question

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CFA Practice Question

If a 10 percent decline in airfares leads to a 5 percent increase in total expenditures on air travel, the price elasticity of demand for air travel in this range must be ______.
A. 0.5
B. elastic
C. inelastic
Explanation: Since a price decline led to an increase in total expenditures on air travel, the demand for air travel must be elastic. This is because elastic demand implies that a 10 percent decline in price will lead to a greater than 10 percent increase in demand. Thus, under elastic demand and a price decline, total expenditures are expected to rise.

User Contributed Comments 14

User Comment
cbb1 If prices decline, but total revenues increased, then the quantity sold must have increase greater than the price decline. If price declined by 10% and quantity increased by 10%, there would be no change in revenues -- and thus, unitary elasticity. In this case, revenues increased thus elastic (above 1.0).
CHADZAMIRA The solution to this question has to be very wrong. Demand in this case cannot be said to be elastic when a 10% price fall led to a 5% increase in expenditure. Reduced to figures this means price elasticity of demand is 0.5 < 1, therefore inelastic. The formula for price elasticity of demand is %dQ/%dP, and if the coefficient is 0<x<1, demand is inelastic. The importnat issue is the magnitude of change not, whether revenues change.
nike No CHADZAMIRA. You messed up with demand increase and expenditure increase. In this situation, price is reduced and demand will increase (for a normal goods). The total expenditure can increase (demand is elastic), decrease (inelastic) or remain the same (unitary).
danrow I thought that elastic meant that when there is a 1% decrease in price there is more than 1% in quantity demanded. If the price is decreased by 10% and quantity only increases by 5%, the demand shouldnt' be the demand inelastic? the definition of inelastic is that is not very responsive to changes in price, isn't it? Inelastic does not necessary mean that the demand will fall as the price falls.
I agree with chadzamira
octavianus Price decreased, but the change in quantity is not given, only the change in TOTAL EXPENDITURES.

Total Expenditures = Total Revenue = P X Q

Q is a component of TOTAL EXPENDITURES
steved333 OOOHHHHHH! Thanks, octavianus. I was thinking that perhaps the reason the answer was not .5 was because it wasn't negative. But your point makes great sense...
afrofrog should read the wording carefully. The 5% increase is for total expenditure, not quantity.
DannyZhou Right to the point, afrofrog. Thanks.
vanillarice I get it. The total expenditure increased. Had there been unit elasticity, the Total expenditure would have remained the same. Had it been inelastic, the Total expenditure would have been negative.
potocah I don't get why 0.5 is wrong!
jpducros A is wrong because if you understand that the demand is elastic (because total expenditure rises), then price elasticity of demand is >1
davcer potocah, as afro mentions 5% is for total expenditure, the 0.5 answer would be for quantity, not expenditure
leo_rhan good one !
bretonpa seems solution is:
after the change in price, we have:
with P1=0.9P0 & E1=1.05E0
solving for Q1/Q0=(E1*P0)/(P1*E0)
replacing E1 and P1, we obtain Q1/Q0=1.05/0.9=1.16
increase on quantity of 16%, thus elastic
Very tricky question
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