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Wednesday, January 12, 2005

Elasticity of demand in the real world

Students often get confused about the concept of elasticity, which is defined as the relative change in one variable due to the relative change in another variable. One of the most basic elasticities used in basic economics is the price elasticity of demand, which indicates the relative change in quantity demanded caused by a relative change in price. Often, determining elasticities is difficult for the outside researcher because of limited information.

However, today's mailbox contained a message from American Airlines about the lower fares the airline has initiated in response to Delta's fare reductions.

Airport: Previous Lowest AA Walk-Up FareNew Lowest AA Walk-Up FarePercent Reduction
Minneapolis/St. Paul, MN (MSP)    $752$49934%
Nashville, TN (BNA)   $636$49922%
Newark, NJ (EWR)$1,095 $49954%
New York LaGuardia, NY (LGA)$1,095 $499 54%
Philadelphia, PA (PHL)   $941 $499 47%
San Diego, CA (SAN)$1,021$49951%
San Francisco, CA (SFO)   $732 $499 32%
Seattle, WA (SEA)$1,109 $499 55%
Washington Reagan Natl., DC (DCA)   $880$49943%

If AA fare reductions are revenue neutral, then the price elasticity of demand is equal to -1 or the percentage increase in demand in each city is equal to the percentage change in price.

Is it reasonable for the number of people flying out of Nashville on the walkup fare to increase by 22%? This might sound impossible, after all a 22% increase in overall traffic would swamp the airlines' capacity. However, these fare reductions are only on the walkup fare, which is the price paid by the business traveller who has to get across the country overnight and has no other alternative travel options. If only 10 people a week buy a walkup fare then a 22% incrase would reflect 2 or three extra people a week. This does not sound unreasonable. If the fare reductions are revenue enhancing, then the percentage increase in walkup fares sold will be greater than the percentage decrease in prices.

Hopefully the folks at AA know what they are doing.

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