Elasticity

Question

On source 4, both the elasticity vlaues are negative. But while solving for elascticty the author has considered price incease for frequesnt flyers and price decrease for exploreres. Also, while calculating for exploreres 990 passenger capacity is considred. I am confused as to why this was taken diffrently.

Answer 1

Hi Deepa,

I only took a quick look but here are my first thoughts.

Yes, price elasticities are negative. That means that changes in quantity are negatively correlated to price and vice versa. Price increase -> Lower volume. Price decrease -> Higher volume. So, in fact, a "normal" correlation between the two as you would expect with most goods. It is negative mathematically because Demand Curves are generally downwards-sloping if you put them in a Q / P chart.

Now, part A of the case clearly states that the capacity (or supply) is 990. So, they try to increase quantity from 900 to 990, basically bringing demand (currently 900) up to the supply (990). Since they want to INCREASE quantity, they need to DECREASE the price (again, this is what negative elasticity means - a negative correlation). In the other presented case, they are trying to lower the quantity, so they have to increase the price.

In Summary: negative price elasticities are the "norm", what you expect - i.e. regular goods, higher price lower vol, lower price higer vol. Luxury items have positive elasticities where a decrease in price would lead to lower quantity (no one would buy Gucci bags if you get them for just a few Dollars). Some other items are closer to or almost 0 (e.g. essential goods such as water, some foods, fuel). No matter the price, people will still buy that stuff.

Hope that helps,

Denis

Answer 2

Hi Deepa,

i agree with Denis. Nothing really seems off here...this is a classic price breakeven problem.

To determine the right price, we have to figure out how much is lost/gained per unit times the total change in units sold.

Most goods have normal price elasticities (i.e. price inversly related to quantity demanded).

That said, watch out for price inelasticity AND inversed elasticity. The classic example for the first one would be addictive items such as drugs (I'll pay any amount to get some), and the classic example for the second is luxury goods (as prices rise I actually want it more, as it's a status symbol)

Answer 3

Another thing to consider is the value of the elasticity. If its close to 0, it's quite inelastic (i.e. change in price does not lead to a change in demand). If its above 1, a change in price leads to a large change in demand.

As the elasticities are -0.5 and -2, an increase in prices will cause demand to drop (which is what we see in the case). The question is: which drops faster?

As the frequent travellers are almost inelastic (-0.5), demand changes slowly with changes in price. So you'll need to drop the price a lot (by 30) in order to raise demand to 990. At a price of 120, you have maximum demand but far less revenue (42.76 million) Collecting 30 € less per person is not compensated by having full occupancy.

In the case of the explorers, the elasticity is -2. (abs(-2) = 2 which is greater than 1), which suggests that it's highly sensitive to price changes. Therefore by dropping price a little, you quickly gain many more clients. So in this case although you collect less per client, because you have more clients, you collect more on the whole.