11.

5 Economic Applications of the Derivative

Question 1: What does the term marginal mean?

Question 2: How are derivatives used to compute elasticity?

Derivatives are perfect for examining change. By their definition, they tells us how one
variable changes when another variable changes. In business and economics, this
allows us to examine how revenue and cost change as the quantity produced and sold
changes. Marginal revenue and marginal cost help a business determine compute
these changes.

Elasticity is used to determine how changes in price affect the quantity demanded by
consumers. Understanding this relationship helps us to determine whether a price
should be increased or decreased.

In this section we’ll examine these terms and apply them to several examples drawn
from businesses operating in the real world.

1
Question 1: What does the term marginal mean?

In economics, the term marginal is used to indicate the change in some benefit or cost
when an additional unit is produced. For instance, the marginal revenue is the change in
total revenue when an additional unit is produced. If we let the total revenue function be
represented by TR  Q  , where Q is the number of units produced and sold, then the

marginal revenue is calculated with the difference

Marginal Revenue  TR  Q  1  TR  Q 

Since this is a difference, it corresponds to a change in revenue. The production levels

Q and Q  1 differ by one units, so TR  Q  1  TR  Q  describes the change in total

revenue when production is changed by one unit.

The marginal revenue can also be interpreted as an average rate of change. Using the
definition of average rate of change, the average rate of change of R  Q  over Q, Q  1

is

Average rate of change TR  Q  1  TR  Q 

  TR  Q  1  TR  Q 
of TR  Q  over Q, Q  1 Q 1 Q

Let’s label these quantities on a graph of a revenue function TR(Q) .

2
 Figure 1 – A revenue function TR(Q) (blue) with a secant line (red) passing through
two points (Q, TR(Q)) and (Q+1, TR(Q+1)).

In addition to being equal to the average rate of change of TR(Q) over Q, Q  1 , we can

view the marginal revenue as a slope. If we calculate the slope of the secant line
between the points  Q, TR  Q   and  Q  1, TR  Q  1  , we get a numerator equal to

TR  Q  1  TR  Q  and denominator equal to 1. This yields the same expression,

TR  Q  1  TR  Q  , as the marginal revenue.

Now let’s compare this slope to the slope of a tangent line to the revenue function
TR(Q) .

3
 Figure 2 - A revenue function R(Q) (blue) with a tangent line (green) at (Q,
R(Q)).

In Figure 2, we have placed the point of tangency on the graph at  Q, TR  Q   . Another

point is placed on the tangent line at Q  1 . Since these points are separated by 1 unit

and the slope of the tangent line is TR  Q  , the points must be separated vertically by

TR  Q 
TR  Q  . This insures that the slope of the tangent line between these points is
1
or TR  Q  .

These graphs may appear almost identical, so let’s compare them side by side.

Figure 3 – A revenue function R(Q) with a secant line (red) and a tangent line (green).

4
The secant line (red) and the tangent line (green) both pass through  Q, TR  Q   .

However, the tangent line is slightly steeper and passes through a slightly higher point
than the secant line. This means the slope of the tangent line is approximately the same
as the slope of the secant line. In terms of the revenue,

TR  Q  1  TR  Q  TR  Q 
  
 1   1

Slope of the secant line Slope of the
tangent line

The marginal revenue at a production level Q is

approximately equal to the derivative of the total revenue
function at Q,

TR  Q  1  TR  Q   TR  Q 

We can evaluate the derivative of the revenue function to estimate the marginal revenue
at any production level.

Example 1 Find and Interpret the Marginal Revenue

Based on sales data from 2000 to 2009, the relationship between the
price per barrel of beer P at the Boston Beer Company and the number
of barrels sold annually, Q, can be modeled by the power function

P  209.7204Q 0.0209

where Q is in thousands of barrels.

5
a. Find the revenue function TR(Q) .

Solution To find the revenue, we must multiply the quantity times the
price. In this example, the quantity of beer is represented by Q in
thousands of barrels and the price per barrel is reprensented by
P  209.7204Q 0.0209 in dollars per barrel. The revenue function is

TR(Q)  Q
  209.7204Q 0.0209

quantity price

Simplifying the function by combining the factors,

TR  Q   209.7204Q 0.9791

where the exponents have been added on the Q factors.

The units of the revenue function are very important. By multiplying the
units on the price and the quantity, we can determine the units on the
revenue function:

 units on   units on   dollars 

   
  thousands of barrels 
 barrel 

 the quantity   the price 
 thousands of dollars

We complete the total revenue function by labeling the units on the

function and write

TR  Q   209.7204Q 0.9791 thousand dollars

b. Find the annual revenue when 1,500,000 barrels of beer are sold.

Solution The annual revenue from 1,500,000 barrels of beer is found by

substituting this production level into R (Q ) . Since Q is in thousands of
barrels, we need to divide the production level by 1000 to scale it
properly,

6
 1,500, 000 barrels 1 thousand barrels
  1500 thousand barrels
1 1000 barrels

1 thousand barrels
The conversion factor, , is equal to 1 and converts
1000 barrels
1,500,000 barrels to 1500 thousand barrels. The revenue at this product
level is

TR (1500)  209.7204 1500   269,992.4558 thousand dollars

0.9791

We can convert this amount to dollars by multiplying by 1000,

269, 992.4558 thousand dollars 1000 dollars

  269, 992, 455.8 dollars
1 1 thousand dollars

c. Approximate the marginal revenue when 1,500,000 barrels of beer

are sold.

Solution The marginal revenue at 1,500,000 barrels of beer is

approximated by TR(1500) . We can find the derivative using the power
rule for derivatives,

d
TR(Q)   209.7204Q 0.9791 
dQ
d
 209.7204 Q 0.9791 
dQ 
Use the Constant Times a Function Rule

 209.7204  0.9791Q .0209  Use the Power Rule

 205.3372Q 0.0209 Multiply the constants

The marginal revenue is approximately

TR(1500)  205.3372 1500 

0.0209
 176.2330

7
 d. How will revenue change if production is increased from 1,500,000
barrels?
Solution The marginal revenue is the same as the instantaneous rate of
change and has the same units. These units are found by dividing the
units on the dependent variable by the units on the independent
variable,

units on the dependent variable thousand dollars dollars

 
units on the independent variable thousand barrels barrels

The marginal revenue is about 176.2330 dollars per barrel meaning that
an increase in production of one barrel will result in an increase in
revenue of approximately 176.23 dollars.

The actual increase is found by subtract the revenue at each level,

TR(1500.001)  TR(1500)  209.7204 1500.001  209.7204 1500 

0.9791 0.9791

 0.17623309 thousand dollars

or 176.23309 dollars.

The marginal cost is the change in cost when an additional unit is produced. If Q units
are produced at a total cost TC (Q ) , the marginal cost is defined as

Marginal Cost  TC  Q  1  TC  Q 

This definition is identical to the definition of marginal revenue except that the total cost
function is used instead of the total revenue function. Like the marginal revenue, the
marginal cost at a production level Q is approximately the same as the derivative of the
total cost function.

8
 The marginal cost at a production level Q is approximately
equal to the derivative of the total cost function at Q,

TC  Q  1  TC  Q   TC   Q 

Example 2 Find and Interpret the Marginal Cost

The total cost TC  Q  to produce Q thousand barrels of beer at the Craft

Brewers Alliance from 2000 to 2009 is given by the function

TC (Q)  0.0024Q 3  2.9978Q 2  961.4000Q  119249.2929

where the cost is in thousands of dollars.

a. Approximate the marginal cost for a production level of 300,000

barrels of beer.

Solution The marginal cost at a production level of 300,000 barrels of

beer is approximated by TC (Q ) at that production level. The derivative
of the cost function is

d
TC (Q)   0.0024Q 3  2.9978Q 2  961.4000Q  119249.2929 
dQ 

 0.0024  3Q 2   2.9978  2Q   961.400 1  0

 0.0072Q 2  5.9956Q  961.4000

Since the quantity Q is in thousands of barrels, we must substitute 300

thousand into TC (Q ) to estimate the marginal revenue at 300,000
barrels. When we do this, we get

TC (300)  0.0072  300   5.9956  300   961.4000

2

 189.28

9
Since this number is a rate, the units on this value is

units on the dependent variable thousand dollars dollars

 
units on the independent variable thousand barrels barrels

a. What does the marginal cost at this production level tell you about
beer production at the Craft Brewers Alliance?

Solution Since costs are increasing at 189.28 dollars per barrel, an

increase in production of 1 barrel (from 300,000 to 300,001 barrels) will
result in an increase in cost of 189.28 dollars.

10
Question 2: How are derivatives used to compute elasticity?

In economics, the term elasticity refers to the responsiveness of one economic variable
to changes in another economic variable. The elasticity is measured in terms of
percentage changes instead of absolute changes. This means we measure the change
in a variable as a percentage of the original amount of the variable. For instance, the
percent change in a variable X is defined as

Change in the variable X

Percent change in X 
Original value of X

This definition can be symbolized in a compact form by symbolizing the change as ∆ X.

If a variable X changes from one value X to another value X

+ ∆ X, then

X
Percent change in X 
X

Suppose that the value of X changes from 20 to 30. The percentage change is

30  20
Percent change in X   0.5
20

Written as a percentage, this is a percentage change in X of 50%.

If we wish to find the elasticity of Y with respect to X, we find the ratio of the percentage
change in Y to the percentage change in X.

The elasticity of Y with respect to X is

Percent change in Y
Elasticity of Y with respect to X 
Percent change in X

11
For most elasticity calculations, the percent change in one variable corresponds to an
increase while the other percent change corresponds to a decrease. This means the
numerator and denominator will have opposite signs resulting in a negative value. Some
textbooks will define the elasticity with a negative sign or in absolute values, but we’ll
preserve the sign to emphasize the nature of the percent changes. An elasticity more
negative than -1 indicates that a percent increase in X corresponds to a greater percent
decrease in Y. In this case, we would say that the variable Y is elastic with respect to
variable X.

An elasticity between -1 and 0 indicates that a percent increase in X corresponds to a

smaller percent decrease in Y. In this case, the variable Y is inelastic with respect to the
variable X.

An elasticity of -1 means that a percent increase in X corresponds to an identical

percent decrease in the variable Y. In this case, the variable Y is said to be unit-elastic
with respect to the variable X.

The most common use of elasticity in economics is price elasticity of demand or

elasticity of demand with respect to price. This concept allows us to explore the
responsiveness of the consumer demand for some product or service to changes in the
price of that product or service. If the price of a cup of coffee were to increase, how
would this effect the quantity sold? In 2006, Starbuck’s increased prices on all coffee
drinks by 5 cents. At one franchise in Sacramento, California, the price on a tall coffee
increased from $1.65 to $1.70. As expected, the demand for tall coffees dropped from
440 units per day to 436 units per day. The percent change in price P is

 P 1.70  1.65
  .03
P 1.65

or about 3%. The percent change in the demand Q is

Q 436  440
  .009
Q 440

12
or about -0.9%. An 3% increase in price corresponds to a 0.9% decrease in the quantity
of tall coffees sold.

The elasticity of demand with respect to price or price elasticity of demand is

Percent change in Q 0.009

E   0.3
Percent change in P .03

0.3
Since this is a ratio, we can think of it as and say that a 1% increase in price
1
corresponds to a 0.3% drop in demand for tall coffee. On the other hand, we could also
0.3
think of this ratio as and say that a 1% drop in price corresponds to a 0.3% increase
1
in demand. Many economics textbooks work in terms of larger price changes and will
3
interpret this ratio as . In this case, we would say that a 10% increase in the price of
10
a tall coffee is accompanied by a 3% decrease in demand.

If the relationship between demand and price is given by a function, we can utilize the
derivative of the demand function to calculate the price elasticity of demand. If we write
think of the change in price as being from P to P   P and the corresponding change in
demand as being from Q to Q  Q , the corresponding percent changes in price and
P Q
demand are and . The definition of elasticity leads to
P Q

Percent change in Q
E Definition of price elasticity of demand
Percent change in P
Q
Q Replace the percent changes with

P appropriate symbols
P
P
Q P Dividing by P is the same as

Q P P
multiplying by the reciprocal  P
P Q
 Rearrange the factors in the
Q P numerators of each fraction.

13
 Q
The factor represents the average rate of change of demand Q with respect to
P
price P. If we assume the change in price is small, we can replace the average rate of
dQ
change with the instantaneous rate of change, .
dP

If the demand Q and the price P are related by a demand

function Q  f ( P ) , then the price elasticity of demand E is

P dQ
E
Q dP

If E  1 , then demand is elastic and a percent increase in

price yields a larger percent decrease in demand.

If 1  E  0 , then demand is inelastic and a percent

increase in price yields a smaller percent decrease in
demand.

Several other cases of elasticity should be mentioned. If E  1 , then the demand is

unit-elastic and a percent increase in price yields the same percent decrease in
demand. Demand is perfectly elastic if any increase in price causes the quantity
demanded to decrease to 0. Demand is perfectly inelastic if and increase or decrease in
price makes no change in the quantity demanded.

Some economists prefer to define elasticity as a positive number by taking the absolute
P dP
value of . This change loses the idea that an increase in price leads to a drop in
Q dQ
the quantity sold, For this reason, we’ll use the definition above for computing price
elasticity of demand.

14
Example 3 Calculate the Price Elasticity of Demand

Using data from market years 2000 through 2010, the relationship
between the price per bushel of oats and the number of bushels of oats
sold is given by

Q  152.07 P 0.543

where P is in dollars and Q is in millions of bushels.

a. Find the price elasticity of demand when the price per bushel is
$1.75.

Solution Since the relationship between the quantity and price is given
as a function of price, we may compute the price elasticity of demand
from

P dQ
E
Q dP

dQ
The derivative is found from the relationship between quantity and
dP
price. Using the Product with a Constant Rule and the Power Rule, we
get

dQ d
 152.07 P 0.543 
dP dP 
 152.07  0.543P 1.543 

 82.574 P 1.543

dQ
Substitute the expression  82.574 P 1.543 for the derivative and the
dP
quantity Q  152.07 P 0.543 into the elasticity formula yields

15
 P dQ
E
Q dP

0.543 
82.574 P 1.543 
P

152.07 P
 0.543

Since the elasticity simplifies to a form that does not contain P, the
elasticity does not depend upon price.

b. Is the demand for oats elastic or inelastic when the price per bushel
is $1.75?

Solution Since the elasticity, E  0.543 , is between -1 and 0, the

elasticity is inelastic. As a consequence, a change in price of 1% will
result in a 0.543% decrease in the quantity demanded.

The product of the price per unit and the quantity demanded is equal to the revenue
from the product. If the quantity demanded decreases as the price is increased, what
will be the overall effect on the total revenue? To answer this question, let’s examine a
table of prices, corresponding quantities, revenue and the elasticity for a product where
the demand function is Q   P  120 .

price P 20 40 60 80 100

quantity Q 100 80 60 40 20

total revenue TR 2000 3200 3600 3200 2000

price elasticity of
-0.2 -0.5 -1 -2 -5
demand E

Even though the slope of the demand curve is -1, the price elasticity of demand
changes as the price increases. For lower prices (green), the price elasticity of demand
is between -1 and 0 and increasing the price increases revenue. For higher prices

16
(blue), the elasticity is more negative than 1 and increasing the price leads to lower
revenue. The highest revenue occurs when the elasticity is equal to -1.

Should prices be increased?

1. If demand is inelastic  1  E  0  , then a price increase

yields an increase in total revenue.

2. If demand is elastic  E  1 , then a price increase yields

a decrease in total revenue.

3. Total revenue is highest at a price where demand is unit-

elastic.

For inelastic demand, price increases are countered by small decreases in the quantity
resulting in more revenue. However, when demand is elastic, price increases lead to
large drops in the quantity sold that lowers the overall revenue. If maximizing revenue is
the overall goal, setting the price where the price elasticity of demand is equal to -1 is
ideal. This goal ignores cost and should be approached cautiously.

Example 4 Calculate the Price Elasticity of Demand

A small technology company in Northern California is developing a

tablet PC to compete with Apple’s Ipad. Based on market surveys, the
company believes the quantity Q (in thousands of units) that will be
demanded by consumers is related to the price P (in thousands of
dollars) by the relationship

Q  4000  250 P 2

17
a. Find the price elasticity of demand when the price of the tablet PC
is $3000.

Solution To compute the price elasticity of demand, we need to find the

derivative of the demand function Q  4000  250 P 2 :

dQ d
  4000  250 P 2 
dP dP 
d d Use the Sum / Difference Rule and
  4000  250  P 2  the Constant Times a Function Rule
dP dP
 0  250  2P  Use the Power Rule

 500 P

Use the derivative and the expression for the quantity Q in the formula
for price elasticity of demand,

P dQ
E
Q dP
P
  500 P 
4000  250 P 2

We can simplify the right hand side of this equation to make it easier to
substitute the price in:

P  500 P 
E Combine factors
4000  250 P 2
500 P 2
 Simplify numerator
4000  250 P 2

A tablet PC priced at 3000 dollars corresponds to P  3 . If we put this

value into the expression for price elasticity of demand, we get

500  3
2

E  2.57
4000  250  3
2

18
Since the elasticity, E  2.57 , is more negative than -1, the demand is
elastic. As a consequence, revenue will drop as the price increases.

b. At what price is the price elasticity of demand equal to -1?

Solution From part a, we know that a price of $3000 is elastic. At lower

prices the demand might be inelastic. To find the dividing line between
elastic and inelastic, we set the price elasticity of demand equal to -1,

500 P 2
  1
4000  250 P 2

Now solve for P:

500 P 2
 4000  250 P 2  4000  250 P 2
 1 4000  250 P 2 
Multiply both sides by the
denominator to clear fraction

500 P 2  4000  250 P 2 Add 250P2 to both sides

750 P 2  4000 Divide both sides by 750

and reduce
16
P2 
3
16 Square root both sides of
P the equation
3

The negative price is not a possible value for the price of a tablet PC.

The other price, P  16

3
, is approximately 2.309. Since P has units of

thousands of dollars, this value corresponds to a price of $2309.

19
 (P,E ) (2.309, -1)

Figure 4 – At the point of intersection, the elasticity is equal to -1. To

the left or right of the point of intersection, the price elasticity of
demand is either lower or higher than -1.

If the price is lower than $2309, the value of E is lower than -1 meaning
demand is inelastic. Prices higher than $2309 result in elastic demand.
This means revenue is maximized at a price of $2309.

20