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ELASTICITYManagerial Economics
Jack Wu
ELASTICITYELASTICITY
NEW YORK CITY TRANSIT AUTHORITY
May 2003: projected deficit of $1 billion over following two years Raised single-ride fares from $1.50 to $2 Raised discount fares
One-day unlimited pass from $4 to $7 30-day unlimited pass from $63 to $70
Increased pay-per-ride MetroCard discount from 10% bonus for purchase of $15 or more to 20% for purchase of $10 or more.
NY MTA
MTA expected to raise an additional $286 million in revenue.
Management projected that average fares would increase from $1.04 to $1.30, and that total subway ridership would decrease by 2.9%.
MANAGERIAL ECONOMICS QUESTION
Would the MTA forecasts be realized? In order to gauge the effects of the price
increases, the MTA needed to predict how the new fares would impact total subway use, as well as how it would affect subway riders’ use of discount fares.
<Note> We can use the concept of elasticity to address these questions.
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
OWN-PRICE ELASTICITY: CALCULATION
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
OWN-PRICE ELASTICITY: SLOPE
Steeper demand curve means demand less elastic
But slope not 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
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
AADVANTAGE1981: American Airlines pioneered frequent flyer program buyer commitment business executives fly at the expense of others
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?
FORECASTING
Forecasting quantity demanded Change in quantity demanded = price elasticity
of demand x change in price
FORECASTING:PRICE INCREASE
If demand elastic, price increase leads to proportionately greater reduction in purchases lower expenditure
If demand inelastic, price increase leads to proportionately smaller reduction in purchases higher expenditure
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.
ADVERTISING ELASTICITY: ESTIMATES
Item Market Elasticity
Beer U.S. 0Wine U.S. 0.08Cigarettes U.S. 0.04
If advertising elasticities are so low, why do manufacturers of beer, wine, cigarettes advertise so heavily?
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
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: 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.