Elasticity LEARNING OBJECTIVES Understand the concepts of own-price elasticity, income elasticity, | cross-price elasticity, and advertising elasticity of demand. * Distinguish price elastic and price inelastic demand. * Appreciate the intuitive factors underlying the elasticity of demand. * Appreciate that, if demand is inelastic, the seller can increase profit | byraising the price. Understand the impact of adjustment time on the elasticity of | demand tor non-durables and durables. | * Appreciate how behavioral biases affect the elasticity of demand. 1. Introduction In 2005, the online retailer Amazon launched its “Prime” service, which provides free two-day shipping with no requirement of a minimum purchase, unlimited. photo storage, and exclusive access to movies, music and Kindle books for a fixed annual fee of $79. In January 2014, when reporting its fourth quarter financial results, Amazon revealed that it was considering raising the price of the Prime service by between $20 and $40.! The investment bank UBS surveyed Amazon Prime subscribers: 58% said that they would renew if Amazon raised the price by $20, while 24% would renew if the price rose by $40. On February 12, UBS reduced its rating of Amazon shares from “Buy” to “Neutral,” and the price of Amazon shares fell,Separately, stockbroker Piper Jaffray surveyed 500 Amazon Prime subscr a asking how likely they would be (o renew their subscription ifthe price were ST to $109. Although 66% of respondents answered that they would be unlikely 3 highly unlikely to renew, analyst Gene Munster argued that, at most, the highly unlikely group or about a quarter of subscribers would not renew. Projecting from prior increases in prices by Netflix and Redbox, Mr Munster concluded that “the two comparable price increases point to a mid single digit percent decrease In Prime customers if Amazon were to raise prices.” In March 2014, Amazon announced a $20 increase for the Prime service. On the day of the announcement, the price of Amazon shares rose by 87 cents or 0.2%. Wedbush Securities analyst Michael Patcher remarked: “A lot of people say they would quit, but the truth is most people get used to the convenience . . . It's like higher fees on credit cards. People complain about them bitterly when they go up, but most never get around to actually changing their service.” Wedbush Secu- rities estimated that Amazon had 25 million Prime subscribers and that the price increase would add about $500 million in revenue and operating profit per year. How would a price increase affect the demand for Amazon's Prime service? How would the price increase affect Amazon's revenues? By how much should Amazon adjust the price of the Prime service? To address these questions, we apply the concept of elasticity. The elasticity of demand measures the responsiveness of demand to changes in an underlying factor, such as the price of the item, the prices of complementary or substitute products, buyers’ income, and advertising expenditure, There is an elasticity cor- responding to every factor that affects demand. The own-price elasticity of demand measures the responsiveness of the quan- tity demanded to changes in the price of the item. With the own-price elasticity, a seller can estimate the impact of an increase or reduction in price on quantity demanded. The selier can then estimate the impact on buyers’ expenditure and its ‘own revenue, Using the own-price elasticity of the demand for the Prime service, Amazon could estimate the impact of the March 2014 price increase on demand and reve- nues. A price increase will always reduce the quantity demanded. We show that a price increase will raise consumers’ expenditure and sellers’ revenue if demand is price inelastic, but reduce consumers’ expenditure and sellers’ revenue if demand is price elastic. Next, we introduce the concepts of income, cross-price, and advertising elastic- ities of demand. Then we discuss how elasticities vary with the time for adjust- ment, and, finally, how behavioral biases affect elasticities. The concept of elasticity is essential to gauging the impact of changes in prices, incomes, and other factors on demand, consumers’ expenditure, and sellers’ rev- enue. It is fundamental to the management of both profit-oriented businesses and non-profit organizations. For instance, just like online retailers Amazon and Alibaba, hospitals and city transport systems need the own-price elasticity to gauge the impact of price increases on demand, revenue, and profit.r Elasticity Blown-Price Elasticity SRE eS x To gauge the impact of changes in price on quantity demanded, we ie a ae of buyers’ sensitivity to price changes — the own-price elasticity of demand. concept of own-price elasticity of demand isso a a itis Omit pics oaiclia often called simply the price elasticity or demant elasticity. damanch The percariage The own-price elasticity of demand is the percentage | by which quantity by which the quantity demanded will change if the price of demanded a change the item rises by 1%. Equivalently, the own-price elasticity is | if price of the ite by 19. the ratio Proportionate change in quantity demanded G1) Proportionate change in price or Percentage change in quantity demanded eo Percentage change in price Estimation To estimate the own-price elasticity of demand, collect records of price changes and the corresponding changes in quantity demanded. Then calculate the own- Price elasticity as the ratio of the proportionate (percentage) change in quantity demanded to the proportionate (percentage) change in price. Zo illustrate, Figure 3.1 represents the demand for cigarettes, Presently, the Price of cigarettes is $1 a pack and the quantity demanded is 1.5 billion packs a month. According to Figure 3.1, if the Price rises to $1.10 per pack, the quantity demanded would drop to 1.44 billion packs. The proportionate change in quantity demanded is the change in quantity demanded divided by the initial quantity demanded. The change in quantity demanded is 1.44 — 1.5 = -0.06 billion packs, and the initial quantity demanded is 1.5 billion packs. Hence, the proportionate change in quantity demanded is ~0.06/1.5 =-0.04. Similarly, the proportionate change in price is the change in price divided by the initial price. The change in Price is $1.10 - $1 = $0.10 per pack, while the initial price is $1 per pack. Hence, the proportionate change in price isO./1=0.1. Thus, by equation (3.1), the own-price elasticity of the demand for cigarettes is~0.04/0.1 =-0.4. Equivalently, in this example, the percentage change in quantity demanded was ~4%, while the percentage change in price was 10%, By equation (3.2), the own-price elasticity is 4/10 =—0.4.me. Elasticity aa 18 ‘Quantity (ition packs e month) FIGURE 3.1 Calculating own-prce elasticity, Note: The own-price elasticity of the demand for cigarettes is the proportionate change in quantity demanded divided by the proportionate change in price =~0.04 +01 --0.4, Properties The cigarette example illustrates several properties of the own-price elasticity of demand. First, as discussed in Chapter 2, demand curves generally slope down- ward: if the price of an item rises, the quantity demanded will fall. Hence, the own-price elasticity is a negative number. For ease of interpretation, some analysts report own-price elasticities as an absolute value, that is, without the negative sign. When applying the concept, note that the own-price elasticity is a negative number, Second, the own-price elasticity is a pure number, independent of the units of measurement. The quantity demanded of cigarettes is measured in billion packs per month. The proportionate change in quantity demanded, however, is the change in quantity demanded divided by the initial quantity demanded. Hence, it is a pure number that does not depend on any units of measurement: the proportionate change would be the same whether we measure quantity demanded in billions, millions, or thousands of packs. Likewise, the proportionate change in price is a pure number. Since the own-price elasticity is the proportionate change in quantity demanded divided by the proportionate change in price, it is also a pure number. Thus, the own-price elasticity of demand provides a handy way of characterizing price sen- sitivity that does not depend on units of measurement. Hence, it can be used to compare the price sensitivity of the demand for different goods and services. Third, recall from equation (3.1) that the own-price elasticity is the ratio of the proportionate change in quantity demanded to the proportionate change in price. If a very large proportionate change in price causes no change in quantity demanded, then the elasticity will be 0. By contrast, if an infinitesimal percentage change ia Price causes a large change in quantity demanded, then the elasticity will be nega- tive infinity. Accordingly, the own-price elasticity ranges from 0 to negative infinity. 8 ene are mS NI a LeElasticity Accuracy pines eee The estimate of the own-price elasticity depends on the calculation of the pro- portionate change, and specifically the denominator of the proportionate change. Equation (3.1) uses the initial prices and quantities as the denominator, but the calculation could also use the average or final prices and quantities. As we consider smaller and smaller price changes, the estimate of the own-price elasticity will con- verge to a single number, which is called the “point estimate” of the elasticity. Evidently, from equation (3.1), the formula using the initial price/quantity as the denominator of the proportionate change in price/quantity is not workable if the initial price/quantity is zero. In that case, we should use either the average or final price/quantity as the denominator. Also, note that the own-price elasticity is a measure that depends on all factors that affect demand — including price, income, prices of complementary and sub- stitute products, and sellers’ advertising. So, changes in any of these may lead to a change in the own-price elasticity, In perticular, the own-price elasticity may vary along the demand curve, and so vary with changes in the price itself, Hence, strictly, the own-price elasticity is accurate only for small changes in the price. PROGRESS CHECK 3A Referring to Figure 3.1, suppose that, intially, the price of cigarettes is $1.10 a pack and the quantity demanded is 1.44 billion packs a month. Then the price falls to $1 per pack and the quantity demanded rises o 1.5 billion pecks. Cal. culate the own-price elasticity. AMAZON PRIME: EFFE OF PRICE INCREASE ish Securities estimated that, at the original price of $79 a year, Amazon ‘had 26 milion subscribers, According to the UBS survey, # Amazon raised by $26, subscriptions would fall by 42% to lies the lasticity of demand is -42/25, according to UBS survey, if Amazon ‘Taised the price Ould fall by 76% to 6 million. Hence, between the prices, $9 of 20/99 Ib f wn-price elastic dis -58.6/20.2 : urces: “Will Amazon Prime customers accept price hike? Maybe not” Forbes, 2, 2004; Wedbush Securities, “Quick note: Amazon.com (AMZN NEUTRAL)" March 13, 2014,Elasticity 3. Elastic/Inelastic Demand The demand for an item is desctibed as price elastic or elastic with respect to price if a 1% increase in price leads to more than a 1% drop in quantity demanded. [rice elastic A price increase causes & proportionately larger reduction in quantity, demanded. — Price inelastic: A price increase causes a proportionately smaller reduction in quantity demanded Equivalently, demand is price elastic if a price increase causes 4 proportionately /arger reduction in quantity demanded. If the demand is elastic, the elasticity is less than -1. This means that the absolute value (that is, without the negative sign) of the elasticity exceeds 1. By contrast, the demand is described as price inelastic or inelastic with respect to price if a 1% price increase causes Jess than a 1% drop in quantity demanded. Equivalently, demand is price inelastic if a price increase causes a propor- tionately smaller reduction in quantity demanded. If the demand is inelastic, the elasticity exceeds -1. This means that the absolute value (that is, without the negative sign) of the elasticity is less than 1. Intuitive Factors To estimate the own-price elasticity requires information on a change in price and the corresponding change in quantity demanded. However, changing the price to estimate the elasticity may be too costly or not practical. As an alternative, managers can consider several intuitive factors to gauge the own-price elasticity of demand. + Availability of direct or indirect substitutes. The fewer substitutes that are available, the less elastic will be the demand. People who are dependent on alcoholic drinks or cigarettes feel that there is no other way to satisfy their needs. Hence, the demand for these items is relatively inelastic. There are fewer substitutes for a product category than for specific products within a category. Consider, for instance, the demand for beer compared with the demand for a particular brand. The particular brand has many more substitutes than the category as a whole. Accordingly, the demand for the brand will tend to be more elastic than the demand for the category. This means that, if beer manufacturers can collectively raise prices by 10%, their sales will fall by a smaller percentage than if single manufacturer increases its price by 10%, + Buyer'sprior commitments. A person who has bought a particular car becomes a captive customer for spare parts, Automobile manufacturers understand this very well. They set relatively higher prices on spare parts than on new cars, The same applies as well in the software business. Once users have invested time and effort to learn one program, they become “locked in” for future upgrades. Whenever there is such a lock-in, demand is less elastic.Typically, commitments unwind over time, For instance, subscribers to 24-month mobile service contracts will be free to switch after 24 months. Accordingly, the effect of buyer commitments on the own-price elasticity of demand will diminish over time. + Benefitslcosts of economizing. Buyers have limited time to spend on searching for better prices, so they focus attention on items that account for relatively larger expenditures. Parents, for instance, spend more time economizing on diapers than on cotton buds, Similarly, office managers focus attention on copying paper rather thaa on paper clips. Marketing practitioners have given the name “Jow involvement” to products that get relatively little attention from buyers. The balance between the benefit and cost of economizing also depends on a possible split between the person who incurs the cost of economizing and the person who benefits. If you bring a damaged car for repair, the repair manager will surely ask: “Are you covered by insurance?” Car owners who are covered by insurance care less about price. They get the benefit of the repair work, while the insurer pays most or all the costs. A car owner who bargains over the repairs must spend his or her own time, while the insurer Will enjoy most of the saving. PROGRESS CHECK 38, ‘What are the intuitive factors that influence the own-price elasticity of demand?4. Forecasting ] The own-price elasticity of demand can be applied to forecast the effect of Price changes on quantity demanded and buyers’ expenditure, Expenditure is related to the quantity demanded, since expenditure equals the quantity demanded mul- tiplied by the price, (In Chapter 9 on pricing, we consider the possibilty of price discrimination, With price discrimination, different buyers pay different prices, sp expenditure is not simply quantity demanded multiplied by price.) The own-price elasticity concept can be applied at the level of an entire market as well as for individual sellers. From the standpoint of an individual seller, the quantity demanded is sales, while buyers’ expenditure is revenue. Hence, using the own-price elasticity of demand, the seller can forecast the effect of price changes on sales and revenue. Quantity Demanded Let us first consider how to use the own-price elasticity of demand to forecast the effect of price changes on the quantity demanded. Refer to the demand for cigarettes in Figure 3.1. Suppose that the price is $1 a pack and the quantity demanded is 1.5 billion packs a month. How would a 5% increase in the price affect the quantity of cigarettes that buyers demand? Above, we calculated the own-price elasticity of demand at the $1 price to be -0.4. By definition, the own-price elasticity is the percentage by which the quantity demanded will change if the price rises by 1%. Hence, if the price of cigarettes increases by 5%, then the quantity demanded will change by ~0.4 x5 = 2%, that is, the quantity demanded will fall by 2%. To forecast the change in quantity demanded in terms of cigarettes, multiply the percentage change of -2% by the quantity demanded before the price change. Accordingly, the 5% price increase would change the quantity demanded by ~2% x 1.5 billion = 30 million packs a month. eh 5 ; As the cigarette example illustrates, the rule for estimating the impact of prices changes on buyers’ quantity demanded is: Proportionate change in quantity demanded = Proportionate change in price x Own-price elasticity of demand, (3.3) We can also use the above rule to estimate the effect of a reduction in the price on the quantity demanded. Suppose that the price of cigarettes is initially Sl a pack and then falls by 5%. The quantity demanded will change by 0.4 x (-5%) = 2%, that is, it will increase by 2%. This example shows that itis important to keep track of the signs of the own-price elasticity and the price change.Team Elasticity ai Expenditure eat let us see how to use the own-price elasticity of demand to estimate the effect vr Shang in price on buyers’ expenditure Buyers’ expenditure equals the quantity y i ‘ice will affect expenditure ded multiplied by the price, Hence, a change in price will affec Goud the price itself as well as through the related effect on quantity demanded. Generally, the rule for estimating the impact of prices changes on buyers’ expenditure is: Proportionate change in expenditure = Proportionate chaage in price 4 Proportionate change in quantity demanded. (3.4) Consider the effect of an increase in price. By itself, the price increase will tend to raise the expenditure. The price increase, however, will reduce the quantity that buyers demand, which would tend to reduce the expenditure, Hence, the net effect ‘on expenditure depends on which effect is relatively larger. The concept of own-price elasticity helps to determine whether the price or quantity effect is relatively larger. Recall that demand is elastic with respect to price if an increase in price causes a proportionately larger fall in quantity demanded, while demand is inelastic if a price increase causes a proportionately smaller fall in quantity demanded. The own-price elasticity enables us to compere the relative magnitude of changes in price and quantity demanded. If the demand is price elastic, then the drop in the quantity demanded will be proportionately larger than the increase in price, and hence, the price increase will reduce expenditure. Generally, if demand is price elastic, a price increase will reduce expenditure while a price reduction will increase expenditure. By contrast, if the demand is price inelastic, the drop in quantity demanded will be proportionately smaller than the increase in price, and then the Price increase will increase expenditure. Generally, if demand is price inelastic, a price increase will increase expenditure while a price reduction will reduce expenditure, To clarify further, substitute from equation (3.3) for the proportionate change in quantity demanded in (3.4). Then the rule for estimating the impact of prices changes on buyers’ expenditure simplifies to: Proportionate change in expenditure = Proportionate change in price x (1 + Own-price elasticity of demand). @.5) Pricing Strategy Whenever sales managers are asked to raise prices, their most frequent response is: “But my sales would drop!” Since demand curves slope downward, it certainlyElasticity. is true that a higher price will reduce sales. The real issue is the extent to which the price increase will reduce sales, Sales managers ought to be thinking about the own-price elasticity of demand, ‘To explain, suppose that a manufacturer's demand is prie inelastic at the current price. What if the manufacturer raises the Price? Since demand is price inelastic, the price increase will lead to a proportionaiely smaller reduction in the quantity demanded. The buyers’ expenditure will increase, which means that the manufac. turer’s revenue will increase, Meanwhile, owing to the reduction in quantity demanded, the manufacturer can reduce production, cutting its costs, Since revenues will be higher and costs | will be lower, the manufacturer's profits definitely will be higher, Accordingly, if demand is price inelastic, a seller can increase profit by raising price. As this discussion shows, under the right conditions (inelastic demand), a price increase can raise profits even though it may cause sales to drop. Therefore, when setting the price for an item, managers should focus on the ow n-price elasticity of demand. Generally, the price should be raised until the demand becomes price elastic. We will develop this idea further in Chapter 9 on pri PROGRESS CHECK 3C Suppose that the own-price elasticity of the demand for a particular mobile phone service provider is ~2.5. If the service provider raises price by 7%, what would be the proportionate effect antity demanded and buyers’ expenditure? DLS SAUNA Mas lece le ats} i In 2008, the New York Times Media Group eared revenues of $668 million | _ from circulation, $1.07 billion from advertising, and $181 milion from other | ___ Sources. Facing compatition from new media and free newspapers, the Group management decided on a strategy to raise circulation prices and trim less profitable readership, In May 2009, the New York Times planned to raise its weekday cover price from $1.50 to $2, and its Sunday cover price from $5 to $6, The price increase was estimated to raise revenue by $40 million. How reasonable is the estimate of the impact on revenue? We can address this question by using the rule for calculating the impact of a price increase on buyers’ expenditure, equation (3.5). At the current circulation of 1.04 million and price of $1.50, and assuming 300 weekdays a year, the current annual revenue from weekday sales of the Times is 1.04 x $1.50 x 300 million = $468 milion. So, the price increase wes estimated to raise revenue by 40/468 = 8 5%. LaElasticity using on the price increase for weekday papers from $1.50 to'$2, the entage change in price would be (2.00 — 1.50)/1.50 = 0.50/1,50 = 33%, ity of demand must be -0.74. This assumption on the elasticity seems ite reasonable, : jowever, commentators on the price inereases did not mention the ‘impact on advertising revenues. The demand for advertising depends on ‘the circulation of the newspaper. Assuming that the own-price elasticity of lemand is -0.74, the $3% price increase would have changed circulation by 88% x-0.74 =-24%6, The 24% reductionin circulation would havesubstantially duced advertising revenue. ees: “New York Times set to increase price,” Financial Times, May 2, 2009; New York imes Company, Annual Reports 2008 and 2009, Tmaddition to price, the demand for an item also depends on buyers’ incomes, the Prices of complementary and substitute items, and sellers’ advertising, Changes in any of these factors shift the demand curve, There is an elasticity to measure the responsiveness of demand to changes in each factor. Managers can use these elasticities to forecast the effect of changes in these factors, In particular, the elasticities can be used to forecast the effect of changes in multiple factors that occur at the same time. The analysis of elasticities of demand with respect to income, the prices of complementary and substitute items, and sellers’ advertising is quite similar to that for the own-price elasticity. Accordingly, we will focus on the differences for the other elasticities. Income Elasticity The income elasticity of demand measures the sensitivity of demand to changes in buyers’ incomes. By definition, the | Income elasticity: The income elasticity of demand is the percentage by which pea Aa the demand will change if the buyers’ incomes rise by 1%, ERE eee Equivalently, the income elasticity is the ratio by 1%. Percentage change in demand oe 86 Percentage change in buyers’ incomeElasticity For a normal product, if buyers’ incomes rise, the demand will rise, $0 the income elasticity will be positive, By contrast, for an inferior product, if incomes ise, demand will fall, so the income elasticity will be negative. Thus the sign of the income elasticity will depend on whet! her the product is normal or inferior. Hence, itis important to note the sign of the income elasticity, The income elasticity can Tange in value from negative infinity to positive infinity, : Demand is described as income elastic or elastic with Tespect to income if a 1% increase in income causes more than a 1% change in demand. Demand is described as income inelastic ot inelastic with Tespect to income if a 1% increase In Income causes less than a 1% change in demand, The demand for necessities tends to be relatively less income elastic than the demand for discretionary items, Consider, for instance, the demand for Taw food as compared with restaurant meals, Eating in a restaurant is more of a discretion- ary item as compared to cooking at home. Accordingly, the demand for raw food ¥s relatively less income elastic than the demand for restaurant meals. Cross-Price Elasticity : Price elasticity measures the sen- Cross-price bail Sitivity of demand to changes in the Prices of related prod- Gmonititeret’” | ucts By deiniton, me Cross-price elasticity of demand Repioectarcetedion | with respect to another item isthe percentage by whic ns ro08 by 1%. deinand will change ifthe price of the related item rise by 1%, Equivalently, the cros-price elasticity i the ratio Percentage change in demand 7 Percentage change in price of related item” Gn) Advertisii ig Elasticity Fale, eng * | Theadvertising elasticity measures the sensitivity of demand oetties a by 1%, | to changes in the sellers’ advertising expenditure. By defini- —— tion, the advertising elasticity of demand isthe PercentageElasticity by which the demand will change if the sellers’ advertising expenditure rises by 1%, Yquivalently, the advertising elasticity is the ratio Percentage change in demand —— a, (3.8) Percentage change in sellers’ advertising expenditure Generally, an increase in advertising will raise the demand, and so the elastic- ity will be positive, Most advertising is undertaken by individual sellers to pro- mote their own business. By drawing buyers away from competitors, advertising ‘has a much stronger effect on the sales of an individual seller than on the market demand. Accordingly, the advertising: elasticity of the demand faced by an individ- ual seller tends to be larger than the advertising elasticity of the market demand, Forecasting Multiple Factors The business environment will often change in conflicting ways. For instance, incomes may rise, while the prices of substitutes and complements rise as well. a a Late ee the higher income would raise demand, the higher price of tutes Would also raise i i apes demand, but the higher price of complements would What is the net effect on di 1? Thi i i castes nie “mand? This question can be addressed using the the 5% increase in price would change 2%. Further, the 3% increase in incomes .3%, Hence, the net effect of the increases %. Telated products and sellers’ advertising expenditures, ding the prices of PROGRESS CHECK 3D Refer to Section 2 of this cha i ipter for the properties of own-price elastici ‘What are the corresponding Properties of the income elasticity, ee ty?Elasticity bel Asa le] 9r.) CAR CHOICE With gasoline prices falling below $3 a gallon, Americans are buying more SUVs (sport-uutility vehicles) and pick- Up trucks. Mike Jackson, chief executive of auto retailer AutoNation, remarked: “Americans just love big’ Falling gasoline prices have reinforced an existing trend of buying larger vehicles, Between October 2014 and 2016, the percentage of SUVs and trucks rose from 68.5% to 72% of Ford's sales, Brian Johnson, auto analyst at investment bank Barclays, emphasized that buying @ new SUV could save gasoline: “A new Ford Escape [crossover SUV] is more fuel efficient than a 10-year-old Camry" Indeed, in the United States between 1997 and 2005, consumers adjusted to higher gasoline prices by scrapping less fuel-efficient cars and buying more fuel-efficient ones. The cross-price elasticity for fuel economy with respect to gasoline prices was 0.02 in the short run and 0.20 in the long run. Source: Shanjun Ui, Christopher Timmins, and Roger H. von Haefen, “How do gasoline prices atiect feet fuel economy?" American Economie Journal: Economic Policy, Vol. 1, No. 2, ‘August 2009, pp! 113-137, 6. Adjustment Time We have analyzed the elasticities of demand with respect to changes in price, inconie, the prices of related products, and advertising expenditures. In addition, another factor affeets all elasticities: the time available for buyers to adjust. With regard to adjustment time, it is important to distin- Shortrun:Time horizon | Suish the short run from the long run. The short run isa time within which buyers horizon within which a buyer cannot adjust at least one item cannot adjust at least one | of consumption. By contrast, the long run is a time horizon item of consumption. Jong enough for buyers to adjust all items of consumption. To illustrate the distinction, consider how Fred commutes into Chicago. He does not have a car, so he takes the train. To Long run: Time horizon switch from the train to a car, he needs time to buy or lease a long enough for buyers car. Accordingly, with regard to Fred’s choice of transport, to adjust al items of the short run is any period of time shorter than that which he re needs to get a car. The long run is any period of time longer than that which he needs to get a car. Let us now discuss the effect of adjustment time on the elasticities of demand, and how the effect depends on whether the item is durable or non-durable. Non-durables Consider an everyday item such as commuter train services Suppose that one Monday morning, the train operator announces a permanent 10% increase in fares. Manycommuters may have already made plans for that day, so the response to the higher fare may be quite weak on that day, Over time, however, the response will be stron- ger: as more commuters acquire cars, the demand for train services will drop. Generally, for a non-durable good, the longer the time that buyers have to adjust, the bigger will be the response to a price change. Accordingly, the demand for such items will be more elastic in the long run than in the short run, This applies Non-durable good: Demand is more elastic in long run than short run, toall non-durable items, including both goods and services. Figure 3.2 illustrates the short- and long-run demand for a non-durable item. Suppose that the current price is $5 and quantity demanded is 1.5 million units. Ifthe price drops to $4.50, the quantity demanded will rise to 1.6 million units in the short run and 1.75 million units in the long ran, At the price of $5 and quantity demanded of 1.5 million units, the proportion- ate change in the price is ($4.50 - $5)/$5 = -$0,50/85 = -0.1. In the short run, the Proportionate change in the quantity demanded is (1.6 ~ 1.5)/1.5 = 0.1/1.5 = 0.067, Accordingly, the short-run own-price elasticity is 0.067/(0.1) = -0.67. : Sea, theproportionatechange in the quantity demandedis(1.75~1.5)/ This confee iO7- Thus. the long-run own-price elasticity is 0.167/(-.1) =-1.67. Confirms that the demand is more elastic in the longrun than in the short run, Durables The effect of adjustment tirae Somewhat different, For both adjust, which causes demand t. . However, for durables only, tively more elastic in the short on the demand for durabie goods such as cars is durables and non-durables, buyers need time to © be relatively more elastic in the long run, @ countervailing effect causes demand to be rela- Tun. This countervailing effect is especially strong with respect to changes in income. 15 16 1,75 Quantity (million units a month) FIGURE 3.2 Short- and long-run demand for a non-durabe item. Note: If the price drops from $5 to $4.50, the quantity demanded wil rise to 1.6 milion units in the ‘Short run and 1.75 million units in the long run,Elasticity Consider, for instance, the demand for ¢ of several years. Suppose that thete is to keep their cars longer. Some drive: will put off the decision to do so. So dry up until sufficient time passes tha the new lower income. ‘ars. Most drivers buy cars at intervals a drop in incomes. Then drivers will plan 8, Who Were just about to replace their cars, the drop in incomes will cause purchases to at these drivers want to replace their cars at However, in the long run, the effect on sales will be more muted: eventually, all drivers will replace their cars, but less frequently. Thus, the drop in income will cause demand to fall more sharply in the short run than in the long run. Similarly, if income rises, drivers will replace their cars more frequently. Some drivers will find that they want to replace their cars immediately, causing a boom ; in purchases. This boom, however, will last only as long as it Eee rsd takes all such drivers to adjust to their new replacement fre- elastic in ong rn then quency. Thus, the increase in income will tend to cause demand short run, depending on to increase more sharply in the short run than in the long run. the balance between Accordingly, for a durable good, the difference between short time for adustment and and long-run elasticities of demand depends ona balance between replacement frequency. the need for time to adjust and the replacement frequency effect, | PROGRESS CHECK 3E Fora non-durable good, explain why the long-run demand is more elastic than the short-run demand. DEMAI FOR’GASOLINE AND CARS: EFFECT OF TIME People buy gasoline to fuel their cars, So the demand for gasoline depends on the ownership of cars and their fuel efficiency. As households change their cars over time, their demand for gasoline will also change. A Canadian study estimated the demand for gasoline as measured by the fuel consumption per unit of distance. The own-price elasticity was 0.029 in the short run and —0.089 in the long run. Apparently, taking into consideration the long-run impact of gasoline on car ownership, the demand was three times more price elastic in the long run than in the short run. : The same study also estimated the demand for car ownership. The income elasticity of the demand for cars was 0.286 in the short run and 0,391 in the long run. Among Canadians, the long-run demand fot cars was 37% more income elastic than in the short run. The estimates suggest that the effect of. adjustment time outweighed the replacement frequency. - Nathalie Boucher, Source: Philippe Barla, Bernard Lamonde, Luis F. Miranda-Moreno, and Nath uche “Traveled se stock and fuel efficiency of private vehicles in Canada: price elasticities ‘and rebound effect," Transportation, Vol. 36, No. 4, 2009, pp. 989-402.F Elasticity FRREDUNGES Rationality Owing to cognitive limitations and difficulties in self-control, individuals behave with bounded rationality, Bounded rationalityleads to systematic biases in decision making that affect the elasticity of demand. Sunk-cost fallacy. Once a person has incurred a sunk cost, she pe mentally obliged to justify the sunk costand that mental obligation will. affect her subsequent choices, For instance, having paid the annual subscription fee for unlimited shipping, a consumer may feel that she must make more Purchases to justify the annual fee. If the subscription fee is higher, the consumer will feel obliged to spend even more and her demand for shopping will be less price elastic, Anchoring, Facing uncertainty, use Cues, even irrelevant cues, imprecise about their benefit from consumer products. Appreciating this uncertainty, retai ilers set list prices to anchor consumer perceptions of the benefit. To the extent of such anchoring, consumers perceive that prices above the list Price exceed their benefit, while prices below the list price yield buyer surplus, Accordingly, the consumer demand is price elastic at prices above the list price and price inelastic at prices below the list price, individuals need information and may to guide their choices. Consumers may be KEY. TAKEAWAYS The own-price elasticity of demand is 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 @ 1% drop in quantity demanded, and price inelastic fg 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: ()ithas more rect or indirect substitutes; (i) the buyer has fewer prior commitments to the iter; and (i) the benefits of economizing are larger than the eoets tf demand is inelastic, the seller can increase profit by raising the price. ‘The income elasticity of demand is the percentage by which the Cemend will change if buyers’ incomes rise by 19. ‘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 non-durables, the demand is more elastic in the long run than in the short Tun. For durables, the demand may be more or ess elastic in the long run than in the short run, depending on the balance between time for adjustment and replacement frequency. the percentage by which the quantity