Chapter 3 Elasticity 1

 Newspapers has two revenue sources: circulation and advertising  Conventional news medias face new competition.  How do they react to new competition? 2 New York Times

 In 2009, NY Times raised weekday price from $1.50 to $2.  Effect on circulation?  Increase circulation revenue by $40 million?  Effect on advertising? 3 New York Times

4 Learning objectives  Understand the concepts of own-price elasticity, income elasticity, cross-price elasticity, and advertising elasticity of demand.  Recognize the conditions under which demand is price elastic and price inelastic.  Appreciate the intuitive factors underlying the elasticity of demand.  Appreciate that, if demand is inelastic, the seller can increase profit by raising the price.  Understand the impact of adjustment time on the elasticity of demand for nondurables and durables.

5 Outline  Own price elasticity  Elastic/inelastic demand  Forecasting quantity demanded and expenditure  Other elasticities  Adjustment time

6 Own-price elasticity  Definition: percentage change in quantity demanded resulting from 1% increase in price of the item.  Alternatively,  Elasticity is ratio  Pure number, independent of units of measure  Negative number, because higher price leads to reduction in quantity demanded

Own-price elasticity: Calculation  % change in qty = ( )/1.5 x 100 = -4.0%  % change in price = (1.10-1)/1 x 100 = 10% 7

8 Own-price elasticity  Accuracy: Varies along demand curve – accurate for small changes in price  Properties  Pure number  Negative  Ranges from minus infinity to zero

9 Outline  Own price elasticity  Elastic/inelastic demand  Forecasting quantity demanded and expenditure  Other elasticities  Adjustment time

10 Own-price elasticity  Price elastic: 1% price increase leads to more than 1% drop in quantity demanded  Price inelastic: 1% price increase leads to less than 1% drop in quantity demanded

Source: Arie Beresteanu and Shanjun Li, “Gasoline Prices, Government Support, and the Demand for Hybrid Vehicles in the U.S.”, International Economic Review,

12 Own-price elasticity: Factors  Availability of substitutes  Positive effect (more substitutes, more elastic)  E.g., cigarettes, alcoholic drinks  Direct substitutes  MBA education: Dartmouth / NYU / USC  Transportation: American Airlines / British Airways

13 Own-price elasticity: Factors  Indirect (functional)  Human teller / ATM  Business travel / video-conferencing  Dictionary / Google translate  In-house provision (vertical integration)  Make or buy

14 Own-price elasticity: Factors  Buyer’s prior commitments  Negative effect (prior commitments leads to lower elasticity)  User learning and investment,  e.g., software’s lock-in effect  Complementary purchases  spare parts, cartridges  Taste,  e.g, baby formula

15 Outline  Own price elasticity  Elastic/inelastic demand  Forecasting quantity demanded and expenditure  Other elasticities  Adjustment time

Forecasting: Price increase  CEO: “Profits are low. We must raise prices.”  Sales Manager: “But my sales would fall!”  Real issue: How sensitive are buyers to price changes? 16

17 Forecasting: Price increase  If demand elastic, price increase leads to  Proportionately greater reduction in purchases  Lower expenditure  If demand inelastic, price increase leads to  Proportionately smaller reduction in purchases  Higher expenditure = higher revenue  Lower cost (producing less => lower variable cost)  Higher profit

18  % change in quantity demand = % change in price * own-price elasticity  % change in expenditure = % change in price + % change in quantity demanded = % change in price * (1+ own-price elasticity) Forecasting: Price increase

19 New York Times, May 2009  Price increase: $1.50 to $2 = 33%  Revenue  Current: $468 million  Estimated increase: $40 million = 8.5%  Implied elasticity  Prop change in revenue = prop change in price x (1 + own-price elasticity)  Implied elasticity = ÷ 0.33 – 1 = – 0.74 (inelastic)  Impact on advertising  Change in circulation: 33% x (– 0.74) = – 24%  Advertising revenue declines due to lower circulation

20 New York Times  “Our respected brands have garnered continued growth in print circulation revenues, which rose 3% in 2009 — mainly because of higher subscription and newsstand prices at The Times and the Globe — despite lower circulation volume. Over the past few years, our newspapers have been focusing on a strategy of reducing less profitable circulation and raising circulation prices. …The Times has more than 820,000 readers who have been subscribing to the print edition for two years or more, up from 650,000 in 2000.” New York Times Company, 2009 Annual Report, page 4

21 Forecasting: Impact of tax  Tax on cigarettes – “win-win”  If demand is price-elastic, then consumption will fall more than proportionately => health gain  If demand is price-inelastic, then consumption will fall less than proportionately => revenue gain

22 Outline  Own price elasticity  Elastic/inelastic demand  Forecasting quantity demanded and expenditure  Other elasticities  Adjustment time

23 Income elasticity  Definition: percentage change in quantity demanded resulting from 1% increase in income.  Alternatively,  normal product: income elasticity > 0  inferior product: income elasticity < 0

24 Income elasticity  In recession, demand for inferior products increases : McDonalds, Walmart  Demand for necessities tends to be relatively less income elastic than the demand for discretionary items

25 Income elasticity: Estimates ItemMarketElasticity Consumer products CigarettesU.S.0.1 LiquorU.S.0.2 Services Electricity (residential)Quebec0.1 TelephoneSpain0.5

26 Cross elasticity  Definition: percentage change in quantity demanded resulting from 1% increase in price of other item.  Alternatively,  Closer substitutes => higher cross-price elasticity:  Important for segmentation –  high cross-elasticity  same segment  low cross-elasticity  separate segments

27 Advertising elasticity  Definition: ( % change in quantity demanded) / ( % change in advertising expenditure.  If advertising elasticities are so low, why do manufacturers of beer, wine, cigarettes advertise so heavily? ItemMarketElasticity BeerU.S.0 WineU.S.0.08 CigarettesU.S.0.04

28 Advertising elasticity  brand owners advertise to draw customers from each other  brand-level demand is more sensitive to advertising than market-level demand

29 Outline  Own price elasticity  Elastic/inelastic demand  Forecasting quantity demanded and expenditure  Other elasticities  Adjustment time

30 Adjustment time  Adjustment time  Time available for buyers to adjust  Short run: buyer cannot adjust at least one item of consumption or usage  Long run: long enough time for buyer to adjust all items

Adjustment time 31

32 Adjustment time: Two factors  Is demand more or less elastic in long run?  Does a price change lead to bigger or smaller effect on quantity in long run? Longer time  more flexibility to adjust Replacement frequency  sharp change non- durables yesno durablesyes

33 Adjustment time: Two factors  A change in income will cause demand to change more sharply in the short run.  For durables, long run demand may be more or less elastic than short run.

Adjustment time: Short/long run elasticities ItemFactorMarketShort- run Long- run CigarettespriceU.S Gasolinepriceintl Gasolineincomeintl ElectricitypriceN.Z AutomobilespriceU.S AutomobilesincomeU.S

35 Key takeaways  The own-price elasticity of demand is the percentage by which the quantity demanded will change if the price of the item rises by 1%.  The demand for an item is price elastic if a 1% increase in price leads to more than a 1% drop in quantity demanded, and price inelastic if a 1% increase in price leads to less than a 1% drop in quantity demanded.  The demand for an item will be more elastic to the extent that: (i) it has more direct or indirect substitutes, (ii) buyer has fewer prior commitments to the item, and (iii) the benefits of economizing are larger than the costs.  If demand is inelastic, the seller can increase profit by raising the price.

36 Key takeaways, cont’d  The income elasticity of demand is the percentage by which the demand will change if the buyers' incomes rise by 1%.  The cross-price elasticity of demand is the percentage by which the demand will change if the price of a related item rises by 1%.  The advertising elasticity of demand is the percentage by which the demand will change if sellers increase advertising expenditure by 1%.  For nondurables, the demand is more elastic in the long run than short run. For durables, the demand may be more or less elastic in the long run than short run, depending on the balance between time for adjustment and replacement frequency.