Elasticity

(c) 1999-2015, I.P.L. Png 1

  NY Times raised weekday
price from $1.50 to $2.
 Effect on circulation?
 Increase circulation
revenue by $40 million?
 Effect on advertising?

(c) 1999-2015, I.P.L. Png 2

Learning objectives

 Understand the concepts of own-price elasticity, income

elasticity, cross-price elasticity, and advertising elasticity
of demand.
 Recognize the conditions under which demand is price
elastic and price inelastic.
 Appreciate the intuitive factors underlying the elasticity of
demand.
 Appreciate that, if demand is inelastic, the seller can
increase profit by raising the price.
 Understand the impact of adjustment time on the
elasticity of demand for nondurables and durables.
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Outline

 Own price elasticity

 Elastic/inelastic demand
 Forecasting quantity demanded and expenditure
 Other elasticities
 Adjustment time

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Own-price elasticity

 Definition: percentage change in quantity demanded

resulting from 1% increase in price of the item.
 Alternatively,
% change in quantity demanded
% change in price
 Elasticity is ratio
 Pure number, independent of units of measure
 Negative number, because higher price leads to
reduction in quantity demanded

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Own-price elasticity: Calculation
Percent changes
•% change in qty = (1.44-
1.5)/1.5 x 100 = -4.0%
•% change in price = (1.10-
1)/1 x 100 = 10%

 % change in qty = (1.44-

1.5)/1.47 x 100 = -4.08%
 % change in price = (1.10-
1)/1.05 x 100 = 9.52%

6
Own-price elasticity

 Accuracy: Varies along demand curve –

accurate for small changes in price
 Properties
 Pure number
 Negative
 Ranges from minus infinity to zero

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Outline

 Own price elasticity

 Elastic/inelastic demand
 Forecasting quantity demanded and expenditure
 Other elasticities
 Adjustment time

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Own-price elasticity

 Elastic: 1% price increase leads to more than

1% drop in quantity demanded
 Elasticity < ̶ 1
 Inelastic: 1% price increase leads to less than
1% drop in quantity demanded
 Elasticity > ̶ 1

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Elasticity at a point
 Limiting case as price change gets smaller and
smaller – collapses to a single point
 Note: Slope = rise/run = P/Q.
Inverse slope = run/rise = Q/P.
 Formula:
 ED = [inverse slope] x [P/Q] OR
 ED = Q/P x [P/Q]
 Elasticity is not the same as slope (or inverse
slope) – not constant along a straight line

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Point Elasticity on a straight line
(absolute values of ED)

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Source: Arie Beresteanu and Shanjun Li, “Gasoline Prices, Government Support, and the Demand for
Hybrid Vehicles in the U.S.”, International Economic Review, 2010.
Source: Arie Beresteanu and Shanjun Li, “Gasoline Prices, Government Support, and the Demand for
Hybrid Vehicles in the U.S.”, International Economic Review, 2010. 13
Own-price elasticity: Factors

 Buyer’s prior commitments

 User learning and investment
 Complementary purchases – spare parts,
customization
 Taste

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Own-price elasticity: Factors

 Cost / benefit of economizing

 Buyer “involvement”
 Separation of buyer / payer
 Insurance
 Frequent flyer

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Outline

 Own price elasticity

 Elastic/inelastic demand
 Forecasting quantity demanded and
expenditure
 Other elasticities
 Adjustment time

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Forecasting: Price increase

 CEO: “Profits are low. We must raise prices.”

 Sales Manager: “But my sales would fall!”
 Real issue: How sensitive are buyers to price
changes?

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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 = higher revenue
 Lower cost (producing less => lower variable
cost)
 Higher profit

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New York Times, May 2009

 Price increase: $1.50 to $2 = 33%

 Revenue
 Current: $468 million
 Estimated increase: $40 million = 8.5%
 Implied elasticity
 Prop change in revenue = prop change in price x (1 +
own-price elasticity)
 Implied elasticity = 0.085 ÷ 0.33 – 1 = – 0.74
(inelastic)
 Impact on advertising
 Change in circulation: 33% x (– 0.74) = – 24%

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New York Times

 “Our respected brands have garnered continued growth

in print circulation revenues, which rose 3% in 2009 —
mainly because of higher subscription and newsstand
prices at The Times and the Globe — despite lower
circulation volume. Over the past few years, our
newspapers have been focusing on a strategy of
reducing less profitable circulation and raising circulation
prices. …The Times has more than 820,000 readers who
have been subscribing to the print edition for two years
or more, up from 650,000 in 2000.”
New York Times Company,
2009 Annual Report, page 4

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Forecasting: Impact of tax

 Tax on cigarettes – “win-win”

 If demand is price-elastic, then consumption
will fall more than proportionately => health
gain
 If demand is price-inelastic, then consumption
will fall less than proportionately => revenue
gain

(c) 1999-2015, I.P.L. Png 21

Outline

 Own price elasticity

 Elastic/inelastic demand
 Forecasting quantity demanded and expenditure
 Other elasticities
 Adjustment time

(c) 1999-2015, I.P.L. Png 22

Income elasticity

 Definition: percentage change in quantity

demanded resulting from 1% increase in
income.
 Alternatively,

% change in quantity demanded

% change in buyers'income

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Income elasticity: Estimates
Item Market Elasticity SR; LR

Consumer products

Cigarettes U.S. 0.1

Liquor U.S. 0.2

Petrol 0.1 ; 0.23

Services

International air travel Intl 1.55

Electricity (residential) Quebec 0.1

Telephone Spain 0.5

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Cross elasticity

 Definition: percentage change in quantity demanded

resulting from 1% increase in price of other item.
 Alternatively,
% change in quantity demanded
% change in price of related item

 Closer substitutes => higher cross-price elasticity:

 Important for segmentation –
 high cross-elasticity  same segment
 low cross-elasticity  separate segments

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Advertising elasticity

 Definition: percentage Item Market Elasticity

change in quantity Beer U.S. 0
demanded resulting from
Wine U.S. 0.08
1% increase in
advertising expenditure. Cigarettes U.S. 0.04
 If advertising elasticities
are so low, why do
manufacturers of beer,
wine, cigarettes advertise
so heavily?

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Advertising elasticity

 Direct effect – raises demand

 Indirect effect – makes demand less sensitive to
price
 Greater brand loyalty

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Outline

 Own price elasticity

 Elastic/inelastic demand
 Forecasting quantity demanded and expenditure
 Other elasticities
 Adjustment time

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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

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Adjustment time

30
Adjustment time: Two factors

 Is demand more or less elastic in long run?

 Does price change lead to bigger or smaller
effect on quantity in long run?

Replacement
Longer time  more
frequency  sharp
flexibility to adjust
change
non-
yes no
durables
durables yes yes

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Adjustment time:
Short/long run elasticities

Item Factor Market Short- Long-

run run
Cigarettes price U.S. -0.2 -3.3
Gasoline price intl -0.23 -0.43
Gasoline income intl 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

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Key takeaways

 The own-price elasticity of demand is the percentage by

which the quantity demanded will change if the price of
the item rises by 1%.
 The demand for an item is price elastic if a 1% increase
in price leads to more than a 1% drop in quantity
demanded, and price inelastic if a 1% increase in price
leads to less than a 1% drop in quantity demanded.
 The demand for an item will be more elastic to the extent
that: (i) it has more direct or indirect substitutes, (ii) buyer
has fewer prior commitments to the item, and (iii) the
benefits of economizing are larger than the costs.
 If demand is inelastic, the seller can increase profit by
raising the price.

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Key takeaways, cont’d

 The income elasticity of demand is the percentage by

which the demand will change if the buyers' incomes rise
by 1%.
 The cross-price elasticity of demand is the percentage
by which the demand will change if the price of a related
item rises by 1%.
 The advertising elasticity of demand is the percentage by
which the demand will change if sellers increase
advertising expenditure by 1%.
 For nondurables, the demand is more elastic in the long
run than short run. For durables, the demand may be
more or less elastic in the long run than short run,
depending on the balance between time for adjustment
and replacement frequency.
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