ELASTICITY

IMBA NCCU
Managerial Economics
Jack Wu
CASE: 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,

%_change_in_quantity_demanded
%_change_in_price
OWN-PRICE ELASTICITY: CALCULATION
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
CALCULATING ELASTICITY
 Point approach:
Elasticity={[Q1-Q2]/Q2}/{[P1-P2]/P2}

% change in qty = (1.5-1.44)/1.44= 4.16%

% change in price = (1-1.10)/1.10=-9.09 %
Elasticity=4.16%/-9.09%=-0.45
CALCULATING ELASTICITY
 Arc Approach (midpoint method):
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
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
 DEMAND CURVES
Price perfectly inelastic
demand

perfectly elastic
demand

0
Quantity
ELASTICITY ON LINEAR DEMAND
CURVE
 Vertical intercept: perfectly elastic
 Upper segment: elastic

 Middle: Unit elastic

 Lower segment: inelastic

 Horizontal intercept: perfectly inelastic

 OWN-PRICE ELASTICITIES
Product Market Elasticity
Automobiles
Chevette U.S. -3.2
Civic U.S. -4
Consumer products
music CDs Aus -1.83
cigarettes U.S. -0.3
liquor U.S. -0.2
football games U.S. -0.275
Utilities
electricity (residential) Quebec -0.7
telephone service Spain -0.1
water (residential) U.S. -0.25
water (industrial) U.S. -0.85
OWN-PRICE ELASTICITY:
DETERMINANTS

 availability of direct or indirect substitutes

 Narrowly defined or Broadly defined market
 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
AADVANTAGE
1981: 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,

%_change_in_quantity_demanded
%_change_in_income
INCOME ELASTICITY
 I >0, Normal good
 I <0, Inferior good

 Among normal goods:

0<I<1, necessity
I>1, luxury
INCOME ELASTICITY
Item Market Elasticity
Consumer products
cigarettes U.S. 0.1
liquor U.S. 0.2
food U.S. 0.8
clothing U.S. 1
newspapers U.S. 0.9
Utilities
electricity (residential) Quebec 0.1
telephone service Spain 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 Elasticity

Consumer products
clothing/food U.S. 0.1
gasoline (competing stn) Boston, MA 1.2
Utilities
electricity/gas (residential) Quebec 0.1
electricity/oil (residential) Quebec 0
bus/subway London 0.25
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. 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?
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.
NON-DURABLE:
SHORT/LONG-RUN DEMAND
Price ($ per unit)

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 Factor Market Short-run Long-run
Nondurables
cigarettes price U.S. -0.3 -3.3
liquor price U.S./Canada -0.2 -1.8
gaseline price U.S. -0.1 -0.5
income U.S. 0 0.3
bus price London -0.8 -1.3
subway price London -0.4 -0.7
railway price Philadelphia -0.5 -1.8
Durables
automobiles price U.S. -0.2 -0.5
income U.S. 3 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