CHAPTER 5 Elasticity: Measuring Responsiveness
When—and where—does price matter most? Southwest knows.
Herb Kelleher, the founder of Southwest Airlines, built his airline from a handful of planes in Texas into a national superpower. His strategy was straightforward but revolutionary: Offer low prices, but no fancy extras. If you’re looking for the lowest price, Southwest is a good place to start.
This strategy has been incredibly successful, but it isn’t one that will always work. Southwest bets that its lower prices will attract enough extra passengers to make up for a lower profit margin on each ticket. We know that lower prices will lead to a higher quantity demanded, but the key question for Southwest is how much higher.
Before Southwest expands into new markets, its executives analyze market research to pinpoint cities and routes where people will respond most vigorously to lower prices. So far, Las Vegas has been Southwest’s biggest success story: Most travelers are there on vacation, and vacationers are especially likely to look for a good deal. By contrast, Southwest has stayed out of routes that are frequently used by business travelers, because their rigid schedules—plus the fact that the boss is paying—mean that business travellers aren’t as responsive to low prices.
As Southwest’s success demonstrates, good business decisions are based on understanding precisely how responsive buyers and sellers are to changing prices. And so in this chapter, we’ll explore how companies like Southwest measure whether buyers and sellers will respond a lot, or a little, to changing prices.
We will start by analyzing the responsiveness of buyers, and then turn to the responsiveness of sellers. Along the way, we’ll also assess how to measure the effects of changing market conditions like changes in income or the prices of other goods.