Download Elasticity

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,
%_change_i n_quantity _demanded
%_change_i n_price
Calculating Elasticity
1.1
1.0
1.44
1.5
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
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
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
Demand Curves
Price
perfectly inelastic
demand
perfectly elastic
demand
0
Quantity
Linear Demand Curve





Vertical intercept: perfectly elastic
Upper segment: elastic
Middle: Unit elastic
Lower segment: inelastic
Horizontal intercept: perfectly inelastic
Own-Price Elasticities
Product
Automobiles
Chevette
Civic
Consumer products
music CDs
cigarettes
liquor
football games
Utilities
electricity (residential)
telephone service
water (residential)
water (industrial)
Market
Elasticity
U.S.
U.S.
-3.2
-4
Aus
U.S.
U.S.
U.S.
-1.83
-0.3
-0.2
-0.275
Quebec
Spain
U.S.
U.S.
-0.7
-0.1
-0.25
-0.85
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,
%_change_i n_quantity _demanded
%_change_i n_income
Income Elasticity



I >0, Normal good
I <0, Inferior good
Among normal goods:
0<I<1, necessity
I>1, luxury
Income Elasticity
Item
Consumer products
cigarettes
liquor
food
clothing
newspapers
Utilities
electricity (residential)
telephone service
Market
Elasticity
U.S.
U.S.
U.S.
U.S.
U.S.
0.1
0.2
0.8
1
0.9
Quebec
Spain
0.1
0.5
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
Item
Market
Consumer products
clothing/food
U.S.
gasoline (competing stn) Boston, MA
Utilities
electricity/gas (residential)
Quebec
electricity/oil (residential)
Quebec
bus/subway
London
Elasticity
0.1
1.2
0.1
0
0.25
Advertising Elasticity:
a=Q%/A%
Definition: percentage change in quantity
demanded resulting from 1% increase
in advertising expenditure.
Advertising Elasticities
Product
beer
wine
cigarettes
clothing
hypert. drugs
recreation
Market
U.S.
U.S.
U.S.
U.S.
U.S.
U.S.
Elasticity
0
0.08
0.04
0.01
0.23 - 0.25
0.08
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
Forecasting Demand

Q%=E*P%+I*Y%+C*Po%+a*A%
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%
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.
Price ($ per unit)
Non-durable:
Short/Long-run Demand
5
4.5
long-run demand
short-run demand
0
1.5
1.6
1.75
Quantity (Million units a month)
Short/Long-run Elasticities
Item
Nondurables
cigarettes
liquor
gaseline
bus
subway
railway
Durables
automobiles
Factor
Market
Short-run Long-run
price
price
price
income
price
price
price
U.S.
U.S./Canada
U.S.
U.S.
London
London
Philadelphia
-0.3
-0.2
-0.1
0
-0.8
-0.4
-0.5
-3.3
-1.8
-0.5
0.3
-1.3
-0.7
-1.8
price
income
U.S.
U.S.
-0.2
3
-0.5
1.4
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