ECON6021 Meeting 2 Elasticity

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ECON6021 Meeting 2 Elasticity
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American Airlines

• Extensive research and many years of experience
  have taught us that business travel demand is
  quite inelasticOn the other hand, pleasure
  travel has substantial elasticity.
• Robert L. Crandall, CEO, 1989

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Topics to be discussed

• Own-Price elasticity of demand
• Elasticity and buyers expenditure
• Other elasticities of demand
• Income elasticity of demand
• Cross price elasticity of demand
• Forecasting demand
• Adjustment Short run versus long run elasticity

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Example 1Tunnel Tolls

• Western tunnel is now charging 40 per trip for
  private cars.
• Is it more profitable to charge a lower price, or
  a higher price?
• Same question to other tunnel
• Another example is why Norton charges David
  Krepss book at different prices in the US and in
  Hong Kong

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Own-Price Elasticity

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

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Calculating Elasticity
change in qty (1.44-1.5)/1.47 x 100 -4.1
change in price (1.10-1)/1.05 x 100
9.5 Elasticity -4.1/9.5 -0.432
/pack 1.1
1.0
1.44
1.5 millions of packs of cigarettes
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Slope and Elasticity

• Steeper demand curve implies demand is less
  elastic
• Slope is not the same as elasticity

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Demand Curves
perfectly inelastic demand
Price
perfectly elastic demand
0
Quantity
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Own-Price Elasticities
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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?
• Why? The question is not really will sales be
  reduced (they will), but how will profits be
  affected?

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Forecasting Expenditure

• A rise in price will
• raise revenue through price
• reduce revenue through sales
• the net effect depends on the elasticity of
  demand.
• If demand is inelastic, why will raising the
  price increase profits?

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Inelastic and Elastic Demand

• Inelastic demand
• Implies the percentage change in quantity
  demanded is less than the percentage change in
  price.
• Price elasticity of demand gt 0 and lt 1
• Elastic demand
• Implies the percentage change in quantity
  demanded is greater than the percentage change in
  price.
• Price elasticity of demand gt 1

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Elasticity, Total Revenueand Expenditure

• Expenditure here refers to the buyers
  expenditure, which equals the sellers revenue
• Total expenditure PQ
• Total Expenditure Test
• Price cut gt total expenditure increases demand
  is elastic.
• Price cut gt total expenditure decreases demand
  is inelastic
• Price cut gt total expenditure does not change
  demand is unit elastic

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Elasticity Along a Straight-Line Demand Curve
500
Lowering the price results in a lower price
elasticity of demand.
Elasticity gt 1
Price (dollars per chip)
400
Elasticity 1
300
250
200
Elasticity lt 1
100
0 40 80 100 120 160
200
Quantity (millions of chips per year)
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Determinants of Own-Price Elasticity

• Availability of direct or indirect substitutes
• Email/Fedexing documents, UPS/Fedexing packages
• Cost / benefit of economizing (low involvement)
• Worth the trouble? Q-tips vs. diapers
• Buyers prior commitments
• Software, baby formula, auto parts, frequent
  flyer programs
• Separation of buyer and payee
• Auto insurance, frequent flyer programs

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AAdvantage

• 1981 American Airlines pioneered the frequent
  flyer program
• Buyer commitment
• Try to get customers locked in
• Business executives fly at the expense of others,
  but they keep the free tickets for personal use

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Income Elasticity

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

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Income Elasticity (cont.)
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Cross-Price Elasticities

• Cross-price elasticity is defined likewise.

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Advertising

• Its direct effect is to raise demand
• It has an indirect effect of making demand less
  sensitive to price
• Own price elasticity for anti-hyper-tension drugs
• Without advertising 2.05
• With advertising 1.6

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Advertising Elasticities
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Forecasting Demand

• Effect on cigarette demand of
• 10 higher income
• 5 less advertising

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Adjustment Time

• Short run
• A time horizon within which a buyer cannot adjust
  at least one item of consumption/usage
• Long run
• A time horizon long enough to adjust all items of
  consumption/usage

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Adjustment Time (cont.)

• Non-durable items
• The longer the time that buyers have for
  adjustment, the bigger the response to a price
  change.
• Durable items
• a countervailing effect (that is, the replacement
  frequency effect) leads demand to be relatively
  more elastic in the short run.

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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)
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Short/Long-run Elasticities