1. Managerial Economics Jack Wu
Elasticity
Managerial Economics
Jack Wu

2. New York City Transit Authority
May 2003: projected deficit of $1 billion over following two years
Raised single-ride fares from $1.50 to $2
Raised discount fares
One-day unlimited pass from $4 to $7
30-day unlimited pass from $63 to $70
Increased pay-per-ride MetroCard discount from 10% bonus for purchase of $15 or more to 20% for purchase of $10 or more.

3. NY MTA MTA expected to raise an additional $286 million in revenue.
Management projected that average fares would increase from $1.04 to $1.30, and that total subway ridership would decrease by 2.9%.

4. MANAGERIAL ECONOMICS QUESTION
Would the MTA forecasts be realized?
In order to gauge the effects of the price increases, the MTA needed to predict how the new fares would impact total subway use, as well as how it would affect subway riders’ use of discount fares.
<Note> We can use the concept of elasticity to address these questions.

5. Own-Price Elasticity: E=Q%/P%
Definition: percentage change in quantity demanded resulting from 1% increase in price of the item. Alternatively,

6. Own-price elasticity: Calculation
Arc approach to deriving the own-price elasticity of demand:
calculate the percentage change in the quantity demanded divided by the percentage change in price;
Example: suppose that,
when cigarette price rises from $1.0/pack to $1.1,
quantity demanded changes from 1.5 to 1.44 billion packs;
then, elasticity = -4.1/9.5 =
Contrast with the point approach to deriving the own-price elasticity of demand
calculates the coefficient from a mathematical equation, in which the quantity demanded is a function of the price and other variables.

7. 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

8. 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

9. Own-Price Elasticity |E|=0, perfectly inelastic
0<|E|<1, inelastic
|E|=1, unit elastic
|E|>1, elastic
|E|=infinity, perfectly elastic

10. Own-price elasticity: Slope
Steeper demand curve means demand less elastic
But slope not same as elasticity
Distinguish between the own-price elasticity of demand and the slope of a demand curve;
example -- straight-line demand curve: same slope throughout, but different elasticity at every point;
steeper is the demand curve, the less elastic is demand, and vice versa.
Own-price elasticity can also vary with changes in any of the other factors that affect demand.

11. DEMAND CURVES perfectly inelastic demand perfectly elastic demand
Price
perfectly elastic demand
Quantity

12. Linear Demand Curve Vertical intercept: perfectly elastic
Upper segment: elastic
Middle: Unit elastic
Lower segment: inelastic
Horizontal intercept: perfectly inelastic

13. Own-Price Elasticities

14. 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

15. 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

16. AAdvantage 1981: American Airlines pioneered frequent flyer program
buyer commitment
business executives fly at the expense of others

17. FORECASTING: 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 would always reduce sales;
real question: how would it affect profit?
answer depends, in part, on price elasticity of demand

18. Forecasting Forecasting quantity demanded
Change in quantity demanded = price elasticity of demand x change in price

19. 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
Buyer’s expenditure = seller’s revenue;
if demand is elastic, reduction in purchases will be proportionately greater than price increase, hence expenditure will fall
if demand is inelastic, reduction in purchases will be proportionately less than price increase, hence expenditure will increase;

20. Income Elasticity, I=Q%/Y%
Definition: percentage change in quantity demanded resulting from 1% increase in income. Alternatively,

21. Income Elasticity I >0, Normal good I <0, Inferior good
Among normal goods:
0<I<1, necessity
I>1, luxury

22. INCOME ELASTICITY

23. 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)

24. Cross-Price Elasticity
C>0, Substitutes
C<0, complements
C=0, independent

25. CROSS-PRICE ELASTICITIES

26. Advertising Elasticity: a=Q%/A%
Definition: percentage change in quantity demanded resulting from 1% increase in advertising expenditure.

27. Advertising elasticity: Estimates
Item
Market
Elasticity
Beer
U.S.
Wine
0.08
Cigarettes
0.04
If advertising elasticities are so low, why do manufacturers of beer, wine, cigarettes advertise so heavily?
Answer: the Table shows advertising elasticities for market demand
brand owners advertise to draw customers from each other – brand-level demand is more sensitive to advertising

28. 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

29. Forecasting Demand
Q%=E*P%+I*Y%+C*Po%+a*A%

30. Forecasting Demand Effect on cigarette demand of 10% higher income
5% less advertising
change
elas.
effect
income
10%
0.1 1%
advert.
-5%
0.04
-0.2%
net
+0.8%

31. 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

32. 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.

33. NON-DURABLE: SHORT/LONG-RUN DEMAND
Price ($ per unit) 5
4.5
long-run demand
short-run demand
1.5
1.6
1.75
Quantity (Million units a month)

34. SHORT/LONG-RUN ELASTICITIES

35. 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

36. 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

37. DISCUSSION QUESTION
Drugs that are not covered by patent can be freely manufactured by anyone. By contrast, the production and sale of patented drugs is tightly controlled. The advertising elasticity of the demand for antihypertensive drugs was around for all drugs, and 0.24 for those covered by patents. For all antihypertensive drugs, the own price elasticity was about -2.0 without advertising, and about -1.6 in the long run with advertising.

38. DISCUSSION QUESTION: CONTINUED
Consider a 5% increase in advertising expenditure. By how much would the demand for a patented drug rise? What about the demand for a drug not covered by patent?
Why is the demand for patented drugs less responsive to advertising than the demand for drugs not covered by patent?
Suppose that a drug manufacturer were to increase advertising. Explain why it should also raise the price of its drugs.