Question

Imagine you work as an economist for an airline (A). Your job entails estimating the passenger demand for airline travel provided by A. You estimate the following:

Price elasticity of demand for A's service= 3

Cross elasticity of demand for A's service (with respect to airline B's price)= 2

Income elasticity of demand for A's service= 1

If a consumer income falls by 5% (because of a recession) and at the same time airline B lowers its price by 10%, all else equal, what would you specifically recommend A due to its price to maintain its quantity of passengers (i.e. lower or raise its price and by what percent)

Answer 1

Income elasticity = % change in demand / % Change in income

1 = % change in demand / (-5%)

% change in demand = - 5% (decrease) [corresponding to fall in income]

Also,

Cross price elasticity = % change in demand of A / % change in price of B

2 = % change in demand of A / (-10%)

% change in demand of A = 2 x (-10%) = -20%  [corresponding to fall in price of B]

Net decrease in demand of A = 5% + 20% = 25%

Finally,

Price elasticity of demand for A = % change in demand of A / % change in price of A

- 3 = - 25% / % change in price of A

3 = 25% / % change in price of A

% change in price of A = 25%/3 = 8.33%

Price of A has to be raised by 8.33%.