4.Elasticity of Demand and Supply

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4. Elasticity of Demand and Supply
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Chapter 4 main menu
4.1 Price elasticity of demand Concept Explorer 4.1 Progress Checkpoint 1 Concept Explorer 4.2 Theory in Life 4.1 Theory in Life 4.2 Progress Checkpoint 2
4.2 Price elasticity of supply Theory in Life 4.3 Theory in Life 4.4 Progress Checkpoint 3
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Concept Explorer 4.1
P ()

• For a straight and downward sloping demand curve,
  its price elasticity of demand is different at
  different price ranges.

Ed gt 1 (above mid-point)
Ed 1 (at mid-point)
Ed lt 1 (below mid-point)
D
Quantity
0
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Progress Checkpoint 1

• Calculate the arc elasticity of demand for the
  following
• (a) Quantity demanded decreases from 20 to 5
  units when price increases from 100 to 150.
• (b) Quantity demanded increases from 1 000 to 1
  350 units when price decreases from 20 to 10.

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Concept Explorer 4.2

• Total revenue, total cost, profit and loss
• A company receives 50 000 total revenue in a
  month. Does this mean that the profit earned by
  the company is also 50 000?
• Total revenue and profit are different. Profit is
  the positive difference between total revenue and
  total cost.
• If the total cost of the company is 30 000 a
  month, the profit will be 50 000 - 30 000 20
  000.

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Concept Explorer 4.2

• Total revenue, total cost, profit and loss
• If the total cost of the company is 90 000 a
  month, the profit will be -40 000 ( 50 000 -
  90 000).
• A negative profit is actually a loss. Loss is the
  negative difference between total revenue and
  total cost.

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Theory in Life 4.1

• Elasticity of demand and phone charges
• Several mobile phone service providers reduced
  their charges recently, while PCCW-HKT increased
  its charge on residential phone service. Did they
  expect the demand for their services to be
  elastic or inelastic?

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Theory in Life 4.1

• When the price of mobile phone service decreases
  from P1 to P2, the quantity demanded increases
  from Q1 to Q2.
• If the demand is elastic (Ed gt 1), i.e. the
  percentage change in quantity demanded is greater
  than the percentage change in price, the gain in
  total revenue will be greater than the loss.
• There will be a net increase in total revenue.

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Theory in Life 4.1

• When the price of residential phone service
  increases from P1 to P2, the quantity demanded
  decreases from Q1 to Q2.
• If the demand is inelastic (Ed lt 1), i.e. the
  percentage change in quantity demanded is less
  than the percentage change in price, the gain in
  total revenue will be greater than the loss.
• There will be a net increase in total revenue.

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Theory in Life 4.2

• Change in total expenditure and mini-bus fare
• During rush hours, there is always long queue for
  mini-bus service. How does an increase in
  mini-bus fare reduce the queue and change the
  total expenditure spent on mini-bus service?

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Theory in Life 4.2

• When the mini-bus fare is at P1, the quantity
  demanded Qd1 is greater than the quantity
  supplied Qs1.
• The shortage is marked ED1 which implies queue
  for mini-bus service.
• Since the quantity transacted is at Qs1, the
  total expenditure spent on mini-bus service is P1
  x Qs1.

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Theory in Life 4.2

• When the fare is increased to P2, quantity
  demanded decreases to Qd2 while quantity supplied
  increases to Qs2.
• The shortage is reduced to ED2 which implies a
  shorter queue.
• Since quantity transacted increases to Qs2, the
  total expenditure increases to P2 x Qs2.

Price ()
S
P2
gain
ED2
P1
D
ED1
Qs1
Qs2
Qd2
Qd1
0
Quantity
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Progress Checkpoint 2

• Both rice and apple are sold in a supermarket.
  The price elasticity of demand for rice is 0.75,
  and that for apple is 1.5.
• The supermarket recently reduced the price of
  rice and raised the price of apple.
• Can these changes increase the total revenue of
  the supermarket? Use well-labelled supply-demand
  diagrams to support your views.

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Progress Checkpoint 2

• If the price of rice decreases from P1 to P2,
  quantity demanded will increase from Q1 to Q2.
• The demand for rice is inelastic, i.e. Ed lt 1, or
  the percentage change in quantity demanded is
  less than the percentage change in price.

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Progress Checkpoint 2
Price ()

• Therefore the gain in revenue will be less than
  the loss.
• This leads to a net decrease in total revenue.
• Such decrease in price cannot increase the total
  revenue of the supermarket.

P1
loss
P2
gain
D
0
Q2
Q1
Quantity
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Progress Checkpoint 2

• If the price of apple increases from P1 to P2,
  quantity demanded decreases from Q1 to Q2.
• The demand for apple is elastic, i.e. Ed gt 1, or
  the percentage change in quantity demanded is
  greater than the percentage change in price.

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Progress Checkpoint 2
Price ()

• Therefore the gain in revenue will be less than
  the loss.
• This leads to a net decrease in total revenue.
• Such increase in price cannot increase the total
  revenue of the supermarket.

P2
gain
P1
loss
D
Q2
Q1
0
Quantity
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Progress Checkpoint 2

• If the demand for a good increases but its price
  does not change, how will total revenue change?
  Explain with the aid of a diagram.
• If the demand for a good increases from D1 to D2
  and the price is constant at P, total revenue
  will increase from P x Q1 to P x Q2, i.e.
  increases by the shaded area.

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Theory in Life 4.3

• Suppose the ticket price of a concert is set
  below equilibrium level.
• As a result, there are insufficient tickets to
  satisfy the demand.
• How will total revenue change if the ticket price
  is adjusted to the equilibrium level?

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Theory in Life 4.3

• As there is a maximum capacity of seats in a
  concert, the supply of concert ticket is
  perfectly inelastic.
• The ticket price is initially set at P1.
• As quantity demanded at Qd is greater than
  quantity supplied or quantity transacted at Qt,
  shortage exists. Total revenue is P1 x Qt.

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Theory in Life 4.3

• If the ticket price increases to P2, quantity
  transacted remains constant at Qt.
• The market is now in equilibrium, and total
  revenue is P2 x Qt, i.e. increases by the shaded
  area.

Price ()
S
P2
gain
P1
shortage
D
Qt
Qd
Quantity
0
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Theory in Life 4.4

• Elasticity of supply and tunnel service
• Since the toll of the Western Harbour Tunnel is
  set too high, excess capacity is always found.
• Will an increase in the toll of the Hunghom
  Cross-Harbour Tunnel increase the total revenue
  and utilization of the Western Harbour Tunnel?

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Theory in Life 4.4

• As there is a maximum capacity of the Western
  Harbour Tunnel, the supply of tunnel service is
  perfectly inelastic, i.e. its supply curve is
  vertical.
• When the demand for its service is at D1 and
  tunnel toll is set at P, there is a surplus of
  tunnel service represented by ES1. Total revenue
  is shown by area P x Qd1.

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Theory in Life 4.4

• If the toll of the Hunghom Cross-Harbour Tunnel
  increases, the demand for Western Harbour Tunnel
  service will increase from D1 to D2. This is
  because they are substitute goods.
• When demand increases from D1 to D2, the surplus
  decreases to ES2, implying an increase in the
  utilization of the tunnel.
• Total revenue also increases to P x Qd2, i.e.
  increases by the shaded area.

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Progress Checkpoint 3

• (a) Calculate the price elasticity of supply if a
  12 decrease in price leads to a 10 decrease in
  quantity supplied.
• (b) Find the percentage change in price if
  quantity supplied decreases by 5 and Es 1.75.
• (c) Find the percentage change in quantity
  supplied if price increases by 7 and Es 0.59.

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Progress Checkpoint 3

• (a)
• (b)
• (c)

The price decreases by 2.86.
The quantity supplied increases by 4.13.
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Progress Checkpoint 3

• For each of the following pair, identify the one
  with more elastic supply. Give reason(s) to
  support your choice.
• (a) Noodle production and ship building
• (b) Medical service and delivery service
• (c) Shoe manufacturing and chicken raising

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Progress Checkpoint 3

• (a) Noodle production has a more elastic supply
  than ship building. This is because noodle
  production is a labour-intensive industry, while
  ship building is a capital-intensive industry.
• (b) Delivery service has a more elastic supply
  than medical service. This is because delivery
  service does not require specialized factors
  while medical service requires.
• (c) Shoe manufacturing has a more elastic supply
  than chicken raising. This is because the
  production period of shoe manufacturing is
  shorter.

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End of Chapter 4