Chapter Three:

Elasticity
Managerial Economics
Lecturer: Chu-Bin Lin
Southwest Jiaotong University

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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.

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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%.

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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

address these questions.

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Own-Price Elasticity:
E=Q%/P%
Definition: percentage change in quantity
demanded resulting from 1% increase in
price of the item.
Alternatively,
% change in quantity demanded
E
% change in price
𝑞2 −𝑞1 ∆𝑞
𝑞1 𝑞
= 𝑝2 −𝑝1 = ∆𝑝
𝑝1 𝑝
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Own-price elasticity:
Calculation
Example:
Price: $1 per pack of cigarettes
Quantity: 1.5 billion packs

Price: $1 -> $1.1

Quantity: 1.5 ->1.44 billion

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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

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Calculating Elasticity
Question:

How about the price drops from $1.1 to $1,

and the quantity increases from 1.44 to 1.5
billion packs?

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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

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Own-Price Elasticity
Accuracy: Varies along demand curve –
accurate for small changes in price

Properties
(1) Negative
(2) Pure number
(3) Ranges from minus infinity to zero

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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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Own-Price elasticity
In absolute value,

|E|=0, perfectly inelastic

0<|E|<1, inelastic
|E|=1, unit elastic
|E|>1, elastic
|E|=infinity, perfectly elastic

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Own-price elasticity:
Slope
1. Steeper demand curve
means demand less elastic
2. But slope is not the same
as elasticity.

∆𝑞
𝑞 ∆𝑞 𝑝
𝐸= ∆𝑝 = ×
∆𝑝 𝑞
𝑝
1
𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛
𝑠𝑙𝑜𝑝𝑒

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Own-price elasticity:
Slope
∆𝑞
𝑞 ∆𝑞 𝑝
𝐸= = ×
∆𝑝 ∆𝑝 𝑞
𝑝
1
𝑙𝑜𝑐𝑎𝑡𝑖𝑜𝑛
𝑠𝑙𝑜𝑝𝑒
Elasticity is related to:
1. Slope
2. Location

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 Demand Curves
Price Less elastic

More elastic

0 Quantity

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 Demand Curves
Price Perfectly inelastic demand

Perfectly elastic
demand

0 Quantity

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Linear Demand Curve
∆𝑞
𝑞 ∆𝑞 𝑝
𝐸= ∆𝑝 = ×
∆𝑝 𝑞
𝑝
1. Vertical intercept: perfectly elastic (p is very high, q is about
to increase from 0)
2. Upper segment: elastic (p is high, q is low)
3. Middle: Unit elastic
4. Lower segment: inelastic (p is low, q is high)
5. Horizontal intercept: perfectly inelastic (p is close to 0, q is
very high)
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 Demand Curves
Price
Elastic

Unit elastic

Perfectly Elastic
Inelastic

Perfectly
Inelastic
0 Quantity

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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

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Own-Price Elasticity:
Determinants
(1) Availability of direct or indirect substitutes
(2) Cost / benefit of economizing (searching
for better price)
◦ 1. “Low involvement” goods
◦ 2. Separation of buyer and payer (Auto insurance)
(3) Buyer’s prior commitments
◦ 1. Cars
◦ 2. Software “locked in”

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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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AAdvantage
Whenever there is a split between the person
who pays and the person who chooses the
product, the demand will be less elastic.

1981: American Airlines pioneered frequent

flyer program
Business executives fly at the expense of
others

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Forecasting:
When to raise price
Situation:
CEO: “Profits are low. We must raise prices.”
Sales Manager: “But our sales would fall!”

Real issue: How sensitive are buyers to

price changes?

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Forecasting
Forecasting quantity demanded
◦ Percentage change in quantity demanded = Price
elasticity of demand x Percentage change in price

∆𝑞
𝑞
𝐸=
∆𝑝
𝑝

∆𝑞 ∆𝑝
=𝐸×
𝑞 𝑝

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Forecasting
Ex. Assume the own-price elasticity of
iPhone 6 is -0.3. How would the quantity
demanded change with 10% increase in its
price?

10% x -0.3 = -3%

The quantity demanded drops by 3% with

10% increase in its price.

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Forecasting:
Price increase
If demand is elastic, price increase leads to
◦ proportionately greater reduction in
purchases
◦ lower expenditure
If demand is inelastic, price increase leads to
◦ proportionately smaller reduction in
purchases
◦ higher expenditure

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Forecasting:
Price increase
If demand is unit elastic, price increase leads
to
◦ The same percentage reduction in
purchases
◦ Expenditure is unchanged

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Forecasting:
Total Expenditure(E)= Price (P) x Quantity (Q)

𝐸 =𝑃×𝑄
𝑑𝐸 𝑑𝑄
=𝑄+𝑃×
𝑑𝑃 𝑑𝑃
𝑑𝐸 𝑃 𝑑𝑄
=𝑄+𝑄× × = 𝑄 + 𝑄 × 𝑒𝑝
𝑑𝑃 𝑄 𝑑𝑃
𝑑𝐸
= 𝑄 × 1 + 𝑒𝑝
𝑑𝑃

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Forecasting:
Both sides divided by 𝑃 × 𝑄 , which is 𝐸

1 𝑑𝐸 1+𝑒𝑝
=
𝐸 𝑑𝑃 𝑃
𝑑𝐸 𝑑𝑃
= 1 + 𝑒𝑝 ×
𝐸 𝑃
𝐸% ≈ 1 + 𝑒𝑝 × 𝑃%

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Forecasting:
𝐸% ≈ 1 + 𝑒𝑝 × 𝑃%

1. 𝑒𝑝 = 0 (perfectly inelastic)
=> +1% in price, 0% decrease in quantity
=> expenditure +1%

2. 0 > 𝑒𝑝 > −1 (inelastic)

=> +1% in price, less than 1% decrease in quantity
=> expenditure increases less than 1%

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Forecasting:
𝐸% ≈ 1 + 𝑒𝑝 × 𝑃%

3. 𝑒𝑝 = −1 (unit elastic)
=> +1% in price, -1% in quantity
=> expenditure is unchanged

4. 𝑒𝑝 < −1 (elastic)
=> +1% in price, more than 1% decrease in quantity
=> expenditure decreases

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

It can be positive or negative. Why?

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Income Elasticity
I >0, Normal good
I <0, Inferior good

Among normal goods:

(1) 0<I<1, necessity
(2) I>1, luxury

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 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

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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

C
% change in price of related item

It can be positive or negative. Why?

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Cross-Price Elasticity
C>0, Substitutes (Pepsi and Coke)
C<0, Complements (gasoline and car)
C=0, Independent or unrelated

Closer substitutes => higher cross-price

elasticity

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 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

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

% change in quantity demanded

a
% change in sellers' advertising expenditure

Is it supposed to be positive or negative?

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 Advertising elasticity:
Estimates
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
advertise so heavily?

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Advertising
(1) Direct effect: raises demand
(2) Indirect effect: makes demand less
sensitive to price (Greater brand loyalty)

Ex.
Own-price elasticity for antihypertensive drugs
Without advertising: -2.05
With advertising: -1.6

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Forecasting Demand

Q% ≈ E*P%+I*Y%+C*Po%+a*A%

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

Change Elasticity Effect

Income 10% 0.1 1%
Advert. -5% 0.04 -0.2%
Net effect +0.8%

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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

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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 (especially strong with
respect to changes in income).

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Adjustment Time
Consider, for instance, the demand for cars. Suppose
that there is a drop in incomes. Then drivers will plan
to keep their cars longer. Some drivers, who were just
about to replace their cars, will put off the decision to
do so.

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.

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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)

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Adjustment time: Two factors

Replacement
Longer time  more
frequency  sharp
flexibility to adjust
change now
Non-
Yes No
durables
Durables Yes Yes

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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

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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

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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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