Recently, Verizon Wireless ran a pricing trial in order to estimate the elasticity
of demand for its services. The manager selected three states that were
representative of its entire service area and increased prices by 5 percent to
customers in those areas. One week later, the number of customers enrolled
in Verizon’s cellular plans declined 4 percent in those states, while
enrollments in states where prices were not increased remained flat. The
manager used this information to estimate the own-price elasticity of demand
and, based on her findings, immediately increased prices in all market areas
by 5 percent in an attempt to boost the company’s 2016 annual revenues.
One year later, the manager was perplexed because Verizon's 2016 annual
revenues were 10 percent lower than those in 2015—the price increase
apparently led to a reduction in the company’s revenues.
Did the manager make an error? Explain.
Yes. The manager was in error. The manager estimated that the short-term
price elasticity of demand was inelastic. In this instance, most Verizon
customers have a contract and, therefore, unable to immediately react to an
increase in price. Consequently, it is possible to see inelastic demand over the
short-term. Still, as Verizon customer contracts terminate and customers have
the opportunity to search for new carriers, and most likely, the demand will
drop. The price increase has caused Verizon to lose more customers than the
manager estimated.
Explanation
The manager of Verizon Wireless estimated that the short-term price elasticity of demand was
inelastic. In the market for cellular service, contracts prevent many customers from immediately
responding to price increases. Therefore, it is not surprising to observe inelastic demand in the
short-term. However, as contracts expire and customers have more time to search for alternatives,
quantity demanded is likely to drop off much more. Given a year or two, the demand for cellular
service is much more elastic. The price increase has caused Verizon to lose more customers than
they initially estimated.
