From Elasticity to Diversion

October 2026 | Applied Economics | Industrial Organization | ← Back to Blog

An earlier post explained why customers don't spread evenly across alternatives when a price rises. This one puts a number on where they go. The diversion ratio separates sales lost to a competitor, to another product you own, or out of the market. That distinction changes how pricing teams evaluate price changes and how merger economists assess competition. The post illustrates the concept using the blocked JetBlue-Spirit merger.

The Question Elasticity Cannot Answer Alone

Elasticity tells you how many sales you lose when you raise price. It does not tell you where those sales go.

That second question often matters more. Take two products with the same own-price elasticity. Raise either price by 5 percent, and each loses the same share of its sales. For the first product, most of those customers go to a direct competitor. For the second, most of them move to another product the same company sells. The elasticity is identical. The business consequence is not.

Elasticity counts the lost sales. Diversion tells you where they went.

From Own-Price Response to Substitution

Own-price elasticity measures how a product's sales respond to its own price. Cross-price elasticity measures how a rival's sales respond to that same price change. Together they describe substitution, but neither one alone tells you where a lost customer ends up.

The diversion ratio does. It is the share of a product's lost sales that a specific alternative picks up when the product's price rises:

D(j → k) = ∂s_k / ∂p_j −∂s_j / ∂p_j

The numerator is how much product k's sales rise when j's price goes up. The denominator is how much j's sales fall. If j loses 100 sales and k gains 40 of them, diversion from j to k is 40 percent.

You can also build diversion from elasticities, but not by dividing one by the other. Elasticities are percentage changes, so each has to be scaled by its own sales first. A 1 percent gain for a large rival is many more customers than a 1 percent gain for a small one.

Why the Destination Matters

When price rises, lost sales go to one of three places.

To a competitor. The sale is gone, and a rival gains it. High diversion to one rival tells you who you actually compete with, including rivals you may not be aware of.

To another product you own. The sale isn't lost; it moves within your portfolio.

Out of the market. Some customers stop buying altogether. In demand models this is the outside option. High diversion to the outside option means more customers are leaving the defined market rather than switching to another product within it.

Elasticity alone counts all three as lost sales. Diversion separates them, so each can be weighed on its own terms.

Diversion in Pricing Strategy

For a pricing team, diversion turns an elasticity estimate into a decision about the whole portfolio.

Start with price increases. If a large share of a product's lost sales goes to another product you own, the increase costs less than its elasticity suggests, because much of the demand stays inside the firm. Whether it pays then depends on the margin of the product that picks it up.

The same substitution patterns matter when evaluating discounts. A promotion that looks successful on its own product may be drawing most of its gains from your other products rather than from rivals. Diversion shows whether a discount is winning customers from competitors or moving them around your own portfolio.

Diversion also defines the competitive set. The rivals that pick up your lost sales are the ones whose prices deserve the closest watch, and that list can differ from the one a team would draw up by instinct.

Diversion in Merger Analysis

Diversion is central to merger review because it measures how close two competitors are. Before a merger, when a firm raises its price, the customers who switch to its rival are a pure loss. After the merger, some of them land on a product the firm now owns, and the margin on those sales is recaptured. A price increase that used to be unprofitable can become profitable.

A standard screening measure, gross upward pricing pressure, puts this in dollars. It multiplies the diversion ratio to the merger partner by the partner's per-unit margin. The result measures the incentive to raise price from recaptured sales, before accounting for any merger-specific efficiencies.

To put this into numbers, take an illustration from my working paper on the blocked JetBlue-Spirit merger. The paper estimates a demand model on a constructed market-level panel calibrated to public fare data and the case record, then uses it to measure substitution between the two airlines on routes named in the case. On Boston to Fort Lauderdale in one quarter, about 38 percent of the sales Spirit would lose to a price increase go to JetBlue. Multiply by JetBlue's margin of about $144, and the merged firm recovers roughly $55, on average, for every sale Spirit loses.¹ That is the incentive to raise Spirit's price, not the price increase itself.

Diversion alone does not settle the price effect. The final outcome also depends on the firm's own margins, how rivals respond, and any cost savings from the merger. That is why a screening measure like this is the starting point, and a full model of pricing comes next.

The Takeaway

Elasticity describes how your product responds to price. Diversion tells you where the lost sales land, and together with margins, what that means for your profits. Pricing teams and merger economists both need the second question answered, not just the first.

Notes

¹ Figures are from my working paper, “Estimating the Price Effects of the Blocked JetBlue-Spirit Merger: A BLP Demand Estimation and Merger Simulation” (October 2026), Table 10, Boston to Fort Lauderdale, first panel quarter. The analysis uses a constructed market-level panel calibrated to public fare data and the case record, so the numbers illustrate the method rather than replicate the government's analysis. The full equilibrium simulation in the paper puts Spirit's price increase in that market-quarter at about $52, close to but not the same as the $55 screening figure. Read the executive summary.