E LASTICITY IMBA Managerial Economics Jack Wu. AMERICAN AIRLINES “ Extensive research and many years of experience have taught us that business travel.

ELASTICITYIMBA 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,

n_price%_change_i

_demandedn_quantity%_change_i

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 is not the same as elasticity

0 Quantity

Price

DEMAND CURVES

perfectly elastic demand

perfectly inelastic demand

LINEAR DEMAND CURVE

Vertical intercept: perfectly elastic Upper segment: elastic Middle: Unit elastic Lower segment: inelastic Horizontal intercept: perfectly inelastic

Product Market ElasticityAutomobilesChevette U.S. -3.2Civic U.S. -4Consumer productsmusic CDs Aus -1.83cigarettes U.S. -0.3liquor U.S. -0.2football games U.S. -0.275Utilitieselectricity (residential) Quebec -0.7telephone service Spain -0.1water (residential) U.S. -0.25water (industrial) U.S. -0.85

OWN-PRICE ELASTICITIES

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

AADVANTAGE1981: 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,

n_income%_change_i

_demandedn_quantity%_change_i

INCOME ELASTICITY

I >0, Normal good I <0, Inferior good Among normal goods: 0<I<1, necessity I>1, luxury

Item Market ElasticityConsumer productscigarettes U.S. 0.1liquor U.S. 0.2food U.S. 0.8clothing U.S. 1newspapers U.S. 0.9Utilitieselectricity (residential) Quebec 0.1telephone service Spain 0.5

INCOME ELASTICITY

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

Item Market ElasticityConsumer productsclothing/food U.S. 0.1gasoline (competing stn) Boston, MA 1.2Utilitieselectricity/gas (residential) Quebec 0.1electricity/oil (residential) Quebec 0bus/subway London 0.25

CROSS-PRICE ELASTICITIES

ADVERTISING ELASTICITY: A=Q%/A%

Definition: percentage change in quantity demanded resulting from 1% increase in advertising expenditure.

Product Market Elasticitybeer U.S. 0wine U.S. 0.08cigarettes U.S. 0.04clothing U.S. 0.01hypert. drugs U.S. 0.23 - 0.25recreation U.S. 0.08

ADVERTISING ELASTICITIES

ADVERTISING

direct effect: raises demand indirect effect: makes demand less sensitive

to price

Own price elasticity for antihypertensive drugsWithout advertising: -2.05With 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.

0

4.5

5

1.5 1.6 1.75

long-run demand

short-run demand

Quantity (Million units a month)

Pri

ce (

$ p

er

unit

)

NON-DURABLE: SHORT/LONG-RUN DEMAND

Item Factor Market Short-run Long-runNondurablescigarettes price U.S. -0.3 -3.3liquor price U.S./Canada -0.2 -1.8gaseline price U.S. -0.1 -0.5

income U.S. 0 0.3bus price London -0.8 -1.3subway price London -0.4 -0.7railway price Philadelphia -0.5 -1.8Durablesautomobiles price U.S. -0.2 -0.5

income U.S. 3 1.4

SHORT/LONG-RUN ELASTICITIES

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

DISCUSSION QUESTION 1

Among commercial users such as apartment buildings, hotels, and offices, the demand for water is estimated to have an own-price elasticity was -0.36, the elasticity with respect to the number of commercial establishments was 0.99, and the elasticity with respect to the average summer temperature was 0.02 (Williams and Suh, 1986).

DISCUSSION QUESTION 1:CONTINUED

Intuitively, would an increase in the number of commercial establishments increase or reduce the demand for water? Is the estimated elasticity consistent with your explanation?

Intuitively, would a rise in the average summer temperature increase or reduce the demand for water? Is the estimated elasticity consistent with your explanation?

By considering the own-price elasticity of demand, explain how the water company could increase its profit.

DISCUSSION QUESTION 2

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 0.26 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.

DISCUSSION QUESTION 2: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.

DISCUSSION QUESTION 3

An Australian telecommunications carrier wants to estimate the own-price elasticity of the demand for international calls to the United States. It has collected annual records of international calls and prices. In each of the following groups, choose the one factor that you would also consider in the regression equation. Explain your reasoning.

DISCUSSION QUESTION 3: CONTINUED

Consumer characteristics: (i) average per capita income, (ii) average age.

Complements: (i) number of telephone lines, (ii) number of mobile telephone subscribers.

Prices of related items: (i) price of electricity, (ii) postage rate from Australia to the United States.