In a recent fare war, America West reduced the price of its roundtrip airfare from Charlotte, North Carolina, to New York City from $198 to $138 to match American Airlines. America West matched the fare reluctantly, saying it would cost the company millions of dollars in revenue. American, on the other hand, believed the fare cut would increase its revenue even if rival airlines matched the lower fares. What different assumptions about the underlying price elasticity of demand for airline tickets on that route did each airline believe true?
In this case, American Airlines believed that demand for tickets on that route was elastic while America West believed that the demand for its tickets was inelastic.
The law of demand tells us that, when prices fall, consumers buy more of a good or service. But the law of demand does not tell us how much more of the product will be bought. This is where elasticity of demand comes in. In some cases, when the price of the product falls, so many more people buy the product that the seller actually ends up making more money than before. In such cases, we say that the demand for the product is elastic. In other cases, the decrease in price does not entice very many more people to buy and revenues drop. We say the demand in such cases is inelastic.
In this example, American Airlines thinks demand is elastic. It thinks that it will make more money by dropping its fares than it would be keeping them high. By contrast, America West thinks demand is inelastic. It thinks that it will lose money when it drops its fares.