1. Elasticity Managerial Economics Jack Wu

2. 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

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

4. Calculating Elasticity 1.1 1.0 1.441.5

5. Calculating Elasticity Arc Approach: Elasticity={[Q2-Q1]/avgQ}/{[P2-P1]/avgP % change in qty = (1.44-1.5)/1.47 = -4.1% % change in price = (1.10-1)/1.05 = 9.5% Elasticity=-4.1%/9.5% =-0.432

6. Calculating Elasticity Point approach: Elasticity={[Q2-Q1]/Q1}/{[P2-P1]/P1} % change in qty = (1.44-1.5)/1.5= -4% % change in price = (1.10-1)/1= 10% Elasticity=-4%/10%=-0.4

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

8. Slope/Elasticity steeper demand curve demand less elastic slope not same as elasticity

9. 0 Quantity Price Demand Curves perfectly elastic demand perfectly inelastic demand

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

11. Own-Price Elasticities

12. 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

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

14. 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?

15. Price Increase: Expenditure if demand elastic, expenditure will fall if demand inelastic, expenditure will rise

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

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

18. Income Elasticity

19. 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)

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

21. Cross-Price Elasticities

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

23. Advertising Elasticities

24. Advertising direct effect: raises demand indirect effect: makes demand less sensitive to price Own price elasticity for antihypertensive drugs Without advertising: -2.05 With advertising:-1.6

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

26. Forecasting Demand Effect on cigarette demand of 10% higher income 5% less advertising changeelas.effect income10%0.11% advert. -5%0.04-0.2% net+0.8%

27. 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

28. 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.

29. 0 4.5 5 1.51.61.75 long-run demand short-run demand Quantity (Million units a month) Price ($ per unit) Non-durable: Short/Long-run Demand

30. Short/Long-run Elasticities

31. 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

32. 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