Elasticity

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 EQ/P

• Definition percentage change in quantity
  demanded resulting from 1 increase in price of
  the item.
• Alternatively,

4
Calculating Elasticity
1.1
1.0
1.44
1.5
5
Calculating Elasticity

• Arc Approach
• ElasticityQ2-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
• ElasticityQ2-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

• E0, perfectly inelastic
• 0ltElt1, inelastic
• E1, unit elastic
• Egt1, elastic
• Einfinity, perfectly elastic

8
Slope/Elasticity

• steeper demand curve lt--gt demand less elastic
• slope not same as elasticity

9
Demand Curves
perfectly inelastic demand
Price
perfectly elastic demand
0
Quantity
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)
• buyers 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, IQ/Y

• Definition percentage change in quantity
  demanded resulting from 1 increase in income.
• Alternatively,

17
Income Elasticity

• I gt0, Normal good
• I lt0, Inferior good
• Among normal goods
• 0ltIlt1, necessity
• Igt1, luxury

18
Income Elasticity
19
Cross-Price Elasticity CQ/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

• Cgt0, Substitutes
• Clt0, complements
• C0, independent

21
Cross-Price Elasticities
22
Advertising Elasticity aQ/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

• QEPIYCPoaA

26
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
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
Non-durable Short/Long-run Demand
5
Price ( per unit)
4.5
long-run demand
short-run demand
0
1.5
1.6
1.75
Quantity (Million units a month)
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