CASE STUDY

Elasticity and Pricing Power: Why Different Consumers Pay Different Prices

All buyers in a highly competitive market pay the same market price for the product, regardless of their individual price Elasticities of demand. If the price rises, Jones may have an elastic demand and greatly reduce her purchases. Green may have a unit-elastic demand and reduce his purchases less than Jones. Lopez may have an inelastic demand and hardly curtail his purchases at all. But all three consumers will pay the single higher price regardless of their respective demand Elasticities.

In later chapters we will find that not all sellers must passively accept a "one-for-all" price. Some firms have "market power" or "pricing power" that allows them to set their product prices in their best interests. For some goods and services, firms may find it advantageous to determine differences in price elasticity of demand and then charge different prices to different buyers. It is extremely difficult to tailor prices for each customer on the basis of price elasticity of demand, but it is relatively easy to observe differences in group Elasticities. Consider airline tickets. Business travelers generally have inelastic demand for air travel. Because their time is highly valuable, they do not see slower modes of transportation as realistic substitutes. Also, their employers pay for their tickets as part of their business expenses. In contrast, leisure travelers tend to have elastic demand. They have the option to drive rather than fly or to simply not travel at all. They also pay for their tickets out of their own pockets and thus are more sensitive to price. Airlines recognize this group difference in price elasticity of demand and charge business travelers more than leisure travelers. To accomplish that, they have to dissuade business travelers from buying the less expensive round-trip tickets aimed at leisure travelers, so they try to place restrictions on the lower-priced tickets. For instance, they have at times made such tickets non refundable, required at least a 2-week advance purchase, and required Saturday-night stays. These restrictions chase off most business travelers who engage in last-minute travel and want to be home for the weekend. As a result, a business traveler often pays hundreds of dollars more for a ticket than a leisure traveler on the same plane. Discounts for children are another example of pricing based on group differences in price elasticity of demand. For many products, children have more elastic demands than adults because children have low budgets, often financed by their parents. Sellers recognize the elasticity difference and price accordingly.

The barber spends as much time cutting a child's hair as an adult's but charges the child much less. A child takes up a full seat at the baseball game but pays a lower price than an adult. A child snowboarder occupies the same space on a chairlift as an adult snowboarder but qualifies for a discounted lift ticket. Finally, consider pricing by colleges and universities. Price elasticity of demand for higher education is greater for prospective students from low-income families than similar students from high-income families. This makes sense because tuition is a much larger proportion of household income for a low-income student or family than for his or her high-income counterpart. Desiring a diverse student body, colleges charge different net prices (tuition minus financial aid) to the two groups on the basis of price elasticity of demand. High-income students pay full tuition, unless they receive merit-based scholarships. Low-income students receive considerable financial aid in addition to merit-based scholarships and, in effect, pay a lower net price. It is common for colleges to announce a large tuition increase and immediately cushion the news by emphasizing that they also are increasing financial aid. In effect, the college is increasing the tuition for students who have inelastic demand by the full amount and raising the net tuition of those with elastic demand by some lesser amount or not at all. Through this strategy, colleges boost revenue to cover rising costs while maintaining affordability for a wide range of students. There are a number of other examples of dual or multiple pricing. All relate directly to price elasticity of demand.

QUESTIONS

a) After reading the case study list at least three examples from around you where multiple pricing is implemented and which is related to price elasticity of demand. [9]

b) Why do you think it is important for producers to have an understanding and knowledge of the concept of price elasticity of demand? Is the law of demand not sufficient for them? [5]

c) Discuss the Total Revenue Test in detail. [6]