In The N Ews

On the Road with Elasticity

How should a firm that operates a private toll road set a price for its service? As the following article makes clear, answering this question requires an understanding of the demand curve and its elasticity.

For Whom the Booth Tolls, Price Really Does Matter

By Steven Pearlstein All businesses face a similar question: What price for their product will generate the maximum profit?

The answer is not always obvious: Raising the price of something often has the effect of reducing sales as price-sensitive consumers seek alternatives or simply do without. For every product, the extent of that sensitivity is different. The trick is to find the point for each where the ideal tradeoff between profit margin and sales volume is achieved.

Right now, the developers of a new private toll road between Leesburg and

Washington-Dulles International Airport are trying to discern the magic point. The group originally projected that it could charge nearly $2 for the 14-mile one-way trip, while attracting 34,000 trips on an average day from overcrowded public roads such as nearby Route 7. But after spending $350 million to build their much heralded "Greenway," they discovered to their dismay that only about a third that number of commuters were willing to pay that much to shave 20 minutes off their daily commute. . . .

It was only when the company, in desperation, lowered the toll to $1 that it came even close to attracting the expected traffic flows.

Although the Greenway still is losing money, it is clearly better off at this new point on the demand curve than it was when it first opened. Average daily revenue today is $22,000, compared with $14,875 when the "special introductory" price was $1.75. And with traffic still light even at rush hour, it is possible that the owners may lower tolls even further in search of higher revenue.

After all, when the price was lowered by 45 percent last spring, it generated a 200 percent increase in volume three months later. If the same ratio applies again, lowering the toll another 25 percent would drive the daily volume up to 38,000 trips, and daily revenue up to nearly $29,000.

The problem, of course, is that the same ratio usually does not apply at every price point, which is why this pricing business is so tricky. . . .

Clifford Winston of the Brookings Institution and John Calfee of the American Enterprise Institute have considered the toll road's dilemma. . . .

Last year, the economists conducted an elaborate market test with 1,170 people across the country who were each presented with a series of options in which they were, in effect, asked to make a personal tradeoff between less commuting time and higher tolls.

In the end, they concluded that the people who placed the highest value on reducing their commuting time already had done so by finding public transportation, living closer to their work, or selecting jobs that allowed them to commute at off-peak hours.

Conversely, those who commuted significant distances had a higher tolerance for traffic congestion and were willing to pay only 20 percent of their hourly pay to save an hour of their time.

Overall, the Winston/Calfee findings help explain why the Greenway's original toll and volume projections were too high: By their reckoning, only commuters who earned at least $30 an hour (about $60,000 a year) would be willing to pay $2 to save 20 minutes.

Source: The Washington Post, October 24, 1996, p. E1.

Percentage change in quantity demanded

Percentage change in income

As we discussed in Chapter 4, most goods are normal goods: Higher income raises quantity demanded. Because quantity demanded and income move in the same direction, normal goods have positive income elasticities. A few goods, such as bus rides, are inferior goods: Higher income lowers the quantity demanded. Because quantity demanded and income move in opposite directions, inferior goods have negative income elasticities.

Even among normal goods, income elasticities vary substantially in size. Necessities, such as food and clothing, tend to have small income elasticities because consumers, regardless of how low their incomes, choose to buy some of these goods. Luxuries, such as caviar and furs, tend to have large income elasticities because consumers feel that they can do without these goods altogether if their income is too low.

cross-price elasticity of demand a measure of how much the quantity demanded of one good responds to a change in the price of another good, computed as the percentage change in quantity demanded of the first good divided by the percentage change in the price of the second good

The Cross-Price Elasticity of Demand Economists use the cross-price elasticity of demand to measure how the quantity demanded of one good changes as the price of another good changes. It is calculated as the percentage change in quantity demanded of good 1 divided by the percentage change in the price of good 2. That is,

Cross-price elasticity of demand

Percentage change in quantity demanded of good 1

Percentage change in the price of good 2

Whether the cross-price elasticity is a positive or negative number depends on whether the two goods are substitutes or complements. As we discussed in Chapter 4, substitutes are goods that are typically used in place of one another, such as hamburgers and hot dogs. An increase in hot dog prices induces people to grill hamburgers instead. Because the price of hot dogs and the quantity of hamburgers demanded move in the same direction, the cross-price elasticity is positive. Conversely, complements are goods that are typically used together, such as computers and software. In this case, the cross-price elasticity is negative, indicating that an increase in the price of computers reduces the quantity of software demanded.

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