Understanding demand elasticities is worth billions of dollars each year to U.S. airlines. ideally, airlines would like to charge a relatively high price to business travelers, while charging leisure passengers a low- enough price to fill up all their
empty seats. That is a strategy for raising revenues and maximizing profits.
But if they charge low-elasticity business travelers one price and high- elasticity leisure passengers a lower price, the airlines have a big problem – keeping the two classes of passengers separate.How can they stop the low -elasticity business travelers from buying up the cheap tickets meant for the leisure travelers and not let high- elasticity leisure flyers take up seats that business passengers would have been willing to buy?
The airlines have solved their problem by engaging in “price discrimination” among their different customers in a way that exploits different price elasticities. price discrimination is the practice of charging different prices for the same service to different customers.Airlines offer discount fares for travelers who plan ahead and who tend to stay longer. One way of separating the two groups is to offer discounted fares to people who stay over a Saturday night-a rule that discourages busies travelers who want to get home for the weekend.Also discounts are often unavailable at the last minute because many business trips are unplanned expeditions to handle an unforeseen crisis- another case of inelastic demand. Airlines have devised extremely sophisticated computer programs to manage their seat availability as a way of ensuring that their low-elasticity passengers cannot benefit from discount fares. As a result, their profits have continued to be healthy while they fill their planes with budget travelers.
The Paradox of the Bumper Harvest
We can use elasticities to illustrate one of the most famous paradoxes of all economics: the paradox of the bumper harvest .. Imagine that in a particular year nature smiles on farming. A cold winter kills olT the pcst~; spring comes early for planting; there are no killing frosts; rains nurture the growing shoots; and a sunny October allows a record crop to come to market. At the end of the year, family Jones happily settles down to calculate its income for the. year.’the Jones es re in for a major surprise: The good weather and bumper crop have Lowell their and other farmers’ incomes.
How can this be? The answer lies in the elasticity of demand for foodstuffs. The demands for basic food products such as wheat and corn tend to be inelastic; for these necessities, consumption changes . very little in response to price. But this means farmers as a whole receive less ‘total revenue when the harvest is good than ‘when it is bad. The increase in supply arising from an abundant harvest tends to lower the price. But the lower price doesn’t increase quantity demanded very much. The implication is . that a low price elasticity of food means that large harvests (high Q) tend to be associated with low revenue (low P X Q).
These ideas can be illustrated by referring back to Figure 4-2. We begin by showing how to measure revenue in the diagram itself. Total revenue is the product of price times quantity, P X Q Further, the area of a rectangle is always·equal to the product of its base times its height. Therefore, total revenue at any point on a demand curve can be found by examining the area of the rectangle. determined by the P and Q at that point.
Next, we can check the relationship between elasticity and revenue for the unit-elastic. case in Figure 472(b). Note that the shaded revenue region (P X Q) is $1000 million for both. points A and B. The shaded areas .representing total revenue are the same because of offsetting changes in the Q base and the P height. This is what we would expect for the borderline case of unit-elastic demand.
We can also see that Figure 4-2(a) corresponds to elastic demand. In this figure, the revenue rectangle expands from $1000 million to $1500 million when price is halved. Since total revenue goes up . when price is cut, demand is elastic.
In Figure 4-2(c) the revenue rectangle falls from $40 million to $30 million when price is halved, so demand is inelastic.
Which diagram illustrates the case of agriculture, where a bumper harvest means lower total revenues for farmers? Clearly it is Figure 4-2(c). Which represents the case of vacation travel, where a lower price could mean higher revenues? Sorely
Table 4-3 shows the major points to remember about price easticities.
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