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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.

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Elasticity

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  1. Elasticity Managerial Economics Jack Wu

  2. 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

  3. Own-Price Elasticity: E=Q%/P% Definition: percentage change in quantity demanded resulting from 1% increase in price of the item. Alternatively,

  4. Calculating Elasticity 1.1 1.0 1.44 1.5

  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

  6. 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

  7. Own-Price Elasticity • |E|=0, perfectly inelastic • 0<|E|<1, inelastic • |E|=1, unit elastic • |E|>1, elastic • |E|=infinity, perfectly elastic

  8. Slope/Elasticity • steeper demand curve <--> demand less elastic • slope not same as elasticity

  9. Demand Curves perfectly inelastic demand Price perfectly elastic demand 0 Quantity

  10. Linear Demand Curve • Vertical intercept: perfectly elastic • Upper segment: elastic • Middle: Unit elastic • Lower segment: inelastic • Horizontal intercept: perfectly inelastic

  11. Own-Price Elasticities

  12. 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

  13. AAdvantage 1981: American Airlines pioneered frequent flyer program • buyer commitment • business executives fly at the expense of others

  14. 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?

  15. Price Increase: Expenditure • if demand elastic, expenditure will fall • if demand inelastic, expenditure will rise

  16. Income Elasticity, I=Q%/Y% Definition: percentage change in quantity demanded resulting from 1% increase in income. Alternatively,

  17. Income Elasticity • I >0, Normal good • I <0, Inferior good • Among normal goods: 0<I<1, necessity I>1, luxury

  18. Income Elasticity

  19. 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)

  20. Cross-Price Elasticity • C>0, Substitutes • C<0, complements • C=0, independent

  21. Cross-Price Elasticities

  22. Advertising Elasticity: a=Q%/A% Definition: percentage change in quantity demanded resulting from 1% increase in advertising expenditure.

  23. Advertising Elasticities

  24. 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

  25. Forecasting Demand • Q%=E*P%+I*Y%+C*Po%+a*A%

  26. Forecasting Demand Effect on cigarette demand of • 10% higher income • 5% less advertising

  27. 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

  28. 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.

  29. Non-durable: Short/Long-run Demand 5 Price ($ per unit) • 4.5 long-run demand short-run demand 0 1.5 1.6 1.75 Quantity (Million units a month)

  30. Short/Long-run Elasticities

  31. 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

  32. 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

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