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Outline. Own-price elasticity Forecasting quantity demanded and expenditure Other elasticities Adjustment time. Own-price elasticity. Definition: percentage change in quantity demanded resulting from 1% increase in price of the item. Alternatively,. Own-price elasticity: Calculation.
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Outline • Own-price elasticity • Forecasting quantity demanded and expenditure • Other elasticities • Adjustment time
Own-price elasticity • Definition: percentage change in quantity demanded resulting from 1% increase in price of the item. • Alternatively,
Own-price elasticity: Calculation • % change in qty = 100*(1.44-1.5)/1.47 = -4.1% • % change in price = 100*(1.10-1)/1.05 = 9.5% • Price elasticity=-4.1%/9.5%=-0.432
Own-price elasticity • Elasticity: 1% price increase leads to more than 1% drop in quantity demanded. • Inelastic: 1% price increase leads to less than 1% drop in quantity demanded.
Own-price elasticity: Slope • Steeper demand curve means demand less elastic • But slope is not the same as elasticity
Own-price elasticity “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, American Airlines, 1989
Own-price elasticity: Factors • Availability of substitutes • Cost / benefit of economizing – buyer’s “involvement”
Own-price elasticity: Factors • Buyer’s prior commitments • Learning: Apple or Dell • complementary purchases: printer and inkjet cartridges • Taste: baby formula • Through smart business strategy: in 1981, American Airlines pioneered frequent flyer program, which became very attractive to business travelers
Outline • Own-price elasticity • Forecasting quantity demanded and expenditure • Other elasticities • Adjustment time
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 total sales revenue (sales revenue=price*quantity demanded) • If demand inelastic, price increase leads to • proportionately smaller reduction in purchases • highertotal sales revenue
Forecasting:Price increase • If demand inelastic, price increase leads to • proportionately smaller reduction in purchases • higherexpenditure = higher sales revenue • Lower sales lower cost • higher profit
Forecasting:Coke vs Pepsi, Nov. 1999 • Coke • raised price • increased advertising • Pepsi followed • Both increased profit (demand was inelastic)
Outline • Own-price elasticity • Forecasting quantity demanded and expenditure • Other elasticities • Adjustment time
Income elasticity • Definition: percentage change in quantity demanded resulting from 1% increase in income. • Alternatively,
Gas Prices: cars versus SUVs • Among 9027 households in the U.S., 38% had one care, 13% two cars, 15% one car and one SUV, 3% two SUVs. • The estimated cross price elasticity of (car+SUV) bundle with respect to gas price is -0.793 • The estimated cross price elasticity of (two cars) bundle with respect to gas price is +0.695
SUV case revisited • Between 2004.9 and 2005.9., gas price increased by 66%. • In response to it, the SUV price dropped by 1.4% (through rebate as incentives) • The own price elasticity of SUV demand is estimated at -2.5, and the cross-elasticity with respect to gas is -0.25. • Therefore, the predicted change in SUV demand would be 66%*-0.25+(-1.4%)*-2.5=-13% • This is close to the actual change in sales: 16.8%!
Advertising elasticity • direct effect – raises demand • indirect effect – makes demand less sensitive to price
Advertising elasticity: Estimates If advertising elasticities are so low, why do manufacturers of beer, wine, cigarettes advertise so heavily? ---brand owners advertise to draw customers from each other – brand-level demand is more sensitive to advertising
Outline • Own-price elasticity • Forecasting quantity demanded and expenditure • Other elasticities • Adjustment time
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
Adjustment time:adjustment time effect and replacement frequency effect • Is demand more or less elastic in long run? • Does income change lead to bigger or smaller effect on quantity in long run?
Summary • Own-price elasticity • Forecasting quantity demanded and expenditure • Other elasticities • Adjustment time
Elasticity: Advanced • Elasticity of y with respect to x
How to apply: easy, easy easy! • Example: y: demand, x: price, demand equation is Y=-10x+20 Elasticity of y with respect to x when x=1 is equal to
Brain Tweezing • Elasticity is different at different x’s. • Try x=0.5 and try x=1.5 and see it yourself!
Brain Tweezing: How to forecast the impact of price change? • Assume: Y=a*x+b • We don’t know a and b • We can estimate a and b using historical sales data: simple regressions. • Then we can calculate the elasticity at any level of x. • Finally, we can forecast the impact of price change on y and the total sales revenue y*x!
