# ELASTICITY by 8VdW3t

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```									ELASTICITY
Managerial Economics
Jack Wu
ELASTICITY
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
OWN-PRICE ELASTICITY: E=Q%/P%
Definition: percentage change in quantity
demanded resulting from 1% increase in price of
the item.
Alternatively,

%_change_i n_quantity _demanded
%_change_i n_price
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
DEMAND CURVES
Price       perfectly inelastic
demand

perfectly elastic
demand

0                               Quantity
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
   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
1981: American Airlines pioneered
frequent flyer program

 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!”
issue: How sensitive are buyers to price
 Real
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_i n_quantity _demanded
%_change_i n_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
Definition: percentage change in quantity
demanded resulting from 1% increase in

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
 direct effect: raises demand
 indirect effect: makes demand less sensitive to
price

Own price elasticity for antihypertensive drugs
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%
 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
 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
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
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.

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