Elasticity Managerial Economics Jack Wu
American Airlines “ Extensive research and many years of experience have taught us that business travel demand is quite inelastic … On the other hand, pleasure travel has substantial elasticity. ” Robert L. Crandall, CEO, 1989
Own-Price Elasticity: E=Q%/P% Definition: percentage change in quantity demanded resulting from 1% increase in price of the item. Alternatively,
Calculating Elasticity
Calculating Elasticity Arc Approach: Elasticity={[Q2-Q1]/avgQ}/{[P2-P1]/avgP % change in qty = ( )/1.47 = -4.1% % change in price = (1.10-1)/1.05 = 9.5% Elasticity=-4.1%/9.5% =-0.432
Calculating Elasticity Point approach: Elasticity={[Q2-Q1]/Q1}/{[P2-P1]/P1} % change in qty = ( )/1.5= -4% % change in price = (1.10-1)/1= 10% Elasticity=-4%/10%=-0.4
Own-Price Elasticity |E|=0, perfectly inelastic 0<|E|<1, inelastic |E|=1, unit elastic |E|>1, elastic |E|=infinity, perfectly elastic
Slope/Elasticity steeper demand curve demand less elastic slope not same as elasticity
0 Quantity Price Demand Curves perfectly elastic demand perfectly inelastic demand
Linear Demand Curve Vertical intercept: perfectly elastic Upper segment: elastic Middle: Unit elastic Lower segment: inelastic Horizontal intercept: perfectly inelastic
Own-Price Elasticities
Own-Price Elasticity: Determinants availability of direct or indirect substitutes cost / benefit of economizing (searching for better price) buyer ’ s prior commitments separation of buyer and payee
AAdvantage 1981: American Airlines pioneered frequent flyer program buyer commitment business executives fly at the expense of others
When to raise price CEO: “ Profits are low. We must raise prices. ” Sales Manager: “ But my sales would fall! ” Real issue: How sensitive are buyers to price changes?
Price Increase: Expenditure if demand elastic, expenditure will fall if demand inelastic, expenditure will rise
Income Elasticity, I=Q%/Y% Definition: percentage change in quantity demanded resulting from 1% increase in income. Alternatively,
Income Elasticity I >0, Normal good I <0, Inferior good Among normal goods: 0<I<1, necessity I>1, luxury
Income Elasticity
Cross-Price Elasticity: C=Q%/Po% Definition: percentage change in quantity demanded for one item resulting from 1% increase in the price of another item. (%change in quantity demanded for one item) / (% change in price of another item)
Cross-Price Elasticity C>0, Substitutes C<0, complements C=0, independent
Cross-Price Elasticities
Advertising Elasticity: a=Q%/A% Definition: percentage change in quantity demanded resulting from 1% increase in advertising expenditure.
Advertising Elasticities
Advertising direct effect: raises demand indirect effect: makes demand less sensitive to price Own price elasticity for antihypertensive drugs Without advertising: With advertising:-1.6
Forecasting Demand Q%=E*P%+I*Y%+C*Po%+a*A%
Forecasting Demand Effect on cigarette demand of 10% higher income 5% less advertising changeelas.effect income10%0.11% advert. -5% % net+0.8%
Adjustment Time short run: time horizon within which a buyer cannot adjust at least one item of consumption/usage long run: time horizon long enough to adjust all items of consumption/usage
Adjustment Time For non-durable items, the longer the time that buyers have to adjust, the bigger will be the response to a price change. For durable items, a countervailing effect (that is, the replacement frequency effect) leads demand to be relatively more elastic in the short run.
long-run demand short-run demand Quantity (Million units a month) Price ($ per unit) Non-durable: Short/Long-run Demand
Short/Long-run Elasticities
Statistical Estimation: Data time series – record of changes over time in one market cross section -- record of data at one time over several markets Panel data: cross section over time
Multiple Regression Statistical technique to estimate the separate effect of each independent variable on the dependent variable dependent variable = variable whose changes are to be explained independent variable = factor affecting the dependent variable