1(c) 1999-2007, I.P.L. Png & D.E. Lehman
Outline
Own-price elasticity Forecasting quantity demanded and
expenditure Other elasticities Adjustment time
2(c) 1999-2007, I.P.L. Png & D.E. Lehman
Own-price elasticity
Definition: percentage change in quantity demanded resulting from 1% increase in price of the item.
Alternatively,
n_price%_change_i
_demandedn_quantity%_change_i
Own-price elasticity: Calculation
% change in qty = 100*(1.44-1.5)/1.47 = -4.1%
% change in price = 100*(1.10-1)/1.05 = 9.5%
Price elasticity=-4.1%/9.5%=-0.432
4(c) 1999-2007, I.P.L. Png & D.E. Lehman
Own-price elasticity
Elasticity: 1% price increase leads to more than 1% drop in quantity demanded.
Inelastic: 1% price increase leads to less than 1% drop in quantity demanded.
Own-price elasticity: Slope
Steeper demand curve means demand less elastic
But slope is not the same as elasticity
Own-price elasticity“ 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, American Airlines, 1989
Own-price elasticity:EstimatesItem Market Elastici
ty
Consumer products
Coffee U.S. -3.06
Cigarettes U.S. -0.2, -0.4
Soft drinks U.S. -3.09
Liquor U.S. -0.2
Services
Electricity (residential) Quebec -0.7
Water (residential) U.S. [-0.2, -0.3]
Water (industrial) U.S. [-0.7, -1.0]
8(c) 1999-2007, I.P.L. Png & D.E. Lehman
Own-price elasticity: Factors
Availability of substitutes Cost / benefit of economizing – buyer’s
“involvement”
9(c) 1999-2007, I.P.L. Png & D.E. Lehman
Own-price elasticity: Factors
Buyer’s prior commitments Learning: Apple or Dell complementary purchases: printer and
inkjet cartridges Taste: baby formula Through smart business strategy: in
1981, American Airlines pioneered frequent flyer program, which became very attractive to business travelers
10(c) 1999-2007, I.P.L. Png & D.E. Lehman
Outline
Own-price elasticity Forecasting quantity demanded
and expenditure Other elasticities Adjustment time
11(c) 1999-2007, I.P.L. Png & D.E. Lehman
Forecasting: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?
12(c) 1999-2007, I.P.L. Png & D.E. Lehman
Forecasting
Forecasting quantity demanded Change in quantity demanded = price
elasticity of demand x change in price
13(c) 1999-2007, I.P.L. Png & D.E. Lehman
Forecasting:Price increase
If demand elastic, price increase leads to proportionately greater reduction in
purchases lower total sales revenue (sales
revenue=price*quantity demanded) If demand inelastic, price increase leads to
proportionately smaller reduction in purchases
higher total sales revenue
14(c) 1999-2007, I.P.L. Png & D.E. Lehman
Forecasting:Price increase
If demand inelastic, price increase leads to proportionately smaller reduction in
purchases higher expenditure = higher sales
revenue Lower sales lower cost higher profit
Forecasting:Coke vs Pepsi, Nov. 1999
Coke raised price increased
advertising Pepsi followed Both increased
profit (demand was inelastic)
16(c) 1999-2007, I.P.L. Png & D.E. Lehman
Outline
Own-price elasticity Forecasting quantity demanded and
expenditure Other elasticities Adjustment time
17(c) 1999-2007, I.P.L. Png & D.E. Lehman
Income elasticity
Definition: percentage change in quantity demanded resulting from 1% increase in income.
Alternatively,
n_income%_change_i
_demandedn_quantity%_change_i
Income elasticity: Estimates
Item Market
Elasticity
Consumer products
Cigarettes U.S. 0.1
Liquor U.S. 0.2
Services
Electricity (residential)
Quebec 0.1
Telephone Spain 0.5
19(c) 1999-2007, I.P.L. Png & D.E. Lehman
Income elasticity: Estimates
Automobiles Market
Elasticity
Domestic-made U.S. 1.62
European-made U.S. 1.93
Asian-made U.S. 1.65
20(c) 1999-2007, I.P.L. Png & D.E. Lehman
Cross elasticity: Estimates
Consumer products/services
Market
Elasticity
Gasoline at competing stations
U.S. 1.2
Electricity/gas Quebec 0.1
Bus/subway London [0.0, 0.5]
Cross elasticity: Estimates
Automobiles Market
Elasticity
Domestic/other brands
U.S. 0.28
European/other brands
U.S. 0.76
Asian/other brands
U.S. 0.61
22(c) 1999-2007, I.P.L. Png & D.E. Lehman
Gas Prices: cars versus SUVs
Among 9027 households in the U.S., 38% had one care, 13% two cars, 15% one car and one SUV, 3% two SUVs.
The estimated cross price elasticity of (car+SUV) bundle with respect to gas price is -0.793
The estimated cross price elasticity of (two cars) bundle with respect to gas price is +0.695
23(c) 1999-2007, I.P.L. Png & D.E. Lehman
SUV case revisited
Between 2004.9 and 2005.9., gas price increased by 66%.
In response to it, the SUV price dropped by 1.4% (through rebate as incentives)
The own price elasticity of SUV demand is estimated at -2.5, and the cross-elasticity with respect to gas is -0.25.
Therefore, the predicted change in SUV demand would be 66%*-0.25+(-1.4%)*-2.5=-13%
This is close to the actual change in sales: 16.8%!
Advertising elasticity
direct effect – raises demand
indirect effect – makes demand less sensitive to price
Advertising elasticity: Estimates
Item Market Elasticity
Beer U.S. 0
Wine U.S. 0.08
Cigarettes U.S. 0.04
If advertising elasticities are so low, why do manufacturers of beer, wine, cigarettes advertise so heavily?
---brand owners advertise to draw customers from each other – brand-level demand is more sensitive to advertising
26(c) 1999-2007, I.P.L. Png & D.E. Lehman
Advertising effect: direct and indirect
Item Market Elasticity
Anti-hypertensive drugs
U.S. Direct:0.26-0.27
The same U.S Indirect: own price elasticity without Ad. [-
2.1,-2.0]
The same U.S. Indirect: own price elasticity with Ad.[-1.7, -
1.5]
27(c) 1999-2007, I.P.L. Png & D.E. Lehman
Outline
Own-price elasticity Forecasting quantity demanded and
expenditure Other elasticities Adjustment time
28(c) 1999-2007, I.P.L. Png & D.E. Lehman
Adjustment time
Definitions Short run: buyer cannot adjust at least
one item of consumption or usage Long run: long enough time for buyer to
adjust all items
Adjustment time:Short/long run elasticities
Item Factor Market
Short-run
Long-run
Cigarettes price U.S. -0.2 -3.3
Gasoline price intern’l -0.23 -0.43
Gasoline income intern’l 0.39 0.81
Electricity price N.Z. -0.18 -0.44
Automobiles price U.S. -0.2 -0.5
Automobiles income U.S. 3.0 1.4
31(c) 1999-2007, I.P.L. Png & D.E. Lehman
Adjustment time:adjustment time effect and replacement frequency effect
Longer time more flexibility to adjust
Replacement frequency sharp change
non-durabl
esyes no
durables
yes yes
Is demand more or less elastic in long run?
Does income change lead to bigger or smaller effect on quantity in long run?
32(c) 1999-2007, I.P.L. Png & D.E. Lehman
Summary
Own-price elasticity Forecasting quantity demanded and
expenditure Other elasticities Adjustment time
33(c) 1999-2007, I.P.L. Png & D.E. Lehman
Elasticity: Advanced
• Elasticity of y with respect to x
0lim ( / ) /( / )
( / ) /( / )
ln / ln
x y y x x
dy dx y x
d y d x
34(c) 1999-2007, I.P.L. Png & D.E. Lehman
How to apply: easy, easy easy!
• Example: y: demand, x: price, demand equation is Y=-10x+20
Elasticity of y with respect to x when x=1 is equal to
( / ) /( / )
10 /
10*1/( 10*1 20)
1
dy dx y x
x y
35(c) 1999-2007, I.P.L. Png & D.E. Lehman
Brain Tweezing
Elasticity is different at different x’s. Try x=0.5 and try x=1.5 and see it
yourself!
36(c) 1999-2007, I.P.L. Png & D.E. Lehman
Brain Tweezing: How to forecast the impact of price change?
Assume: Y=a*x+b We don’t know a and b We can estimate a and b using historical
sales data: simple regressions. Then we can calculate the elasticity at
any level of x. Finally, we can forecast the impact of
price change on y and the total sales revenue y*x!