Download Economics

Economics
Chapter 10
Price elasticity of
Demand and Supply
Law of demand


∆P  ∆Qd , ceteris paribus*
P  Qd  or P   Qd 
P ($)
Q
Given
Qd (unit /day)
Qd (unit /day)
Price
Toy Car
Doll
$100
100
20
$90
110
40
1. When price , Qd ?
Qd of toy car 
Qd of doll 
2. Which one shows greater effect when P  by 10%?
Qd of toy car: 10 units /  10%
Qd of doll: 20 units /  100%
∴ Doll reflects greater respond to ∆P
Price elasticity of demand



Measures the responsiveness of quantity demanded to a
change in price
Percentage change in quantity demanded over one percent
change in price
% ∆ Qd
Ed = ---------%∆ P
Price elasticity of demand


Example (p.75)
When P
Price elasticity of demand


Example (p.76)
When P
Price elasticity of demand


Example (p.76)
Midpoint formula
Price elasticity of demand
Qd (unit /day, P=$100)
Qd (unit /day, P=$90)

Toy Car
Doll
100
20
110
40
Calculate Ed of toy car and doll when



Prices drop
Prices rise
By using midpoint formula
Price elasticity of demand

Given a straight line demand curve :
Slope of demand curve = 6-0 / 0-6 = -1
Slope = 1, with negative relationship between P and Qd

Price elasticity:
If ∆P = $6$0,
∆ Qd = 0 unit 6 units
Ed = %∆ Qd / %∆P
= (∆ Qd / Average Qd ) / (∆P / Average P)
= [(6-0) / ((6+0)/2)] / [(0-6) / ((6+0)/2))]
= -1
Is Ed = Slope of straight line demand curve?

Price elasticity of demand

If ∆P = $5$4, ∆ Qd = 1 unit 2 units
Ed = %∆ Qd / %∆P
= (∆ Qd / Average Qd ) / (∆P / Average P)
= [(2-1) / ((2+1)/2)] / [(5-4) / ((4+5)/2)]
= (1/1.5) / (1/4.5) = 3

Slope of demand curve = 1
Ed ≠Slope of demand curve?

Price elasticity of demand

If ∆P = $4$3, ∆ Qd = 2 unit 3 units
Ed = %∆ Qd / %∆P
= (∆ Qd / Average Qd ) / (∆P / Average P)
= [(3-2) / ((3+2)/2)] / [(4-3) / ((4+3)/2)]
= (1/2.5) / (1/3.5) = 1.4

Slope of demand curve = 1
Ed ≠Slope of demand curve?

Price elasticity of demand

If ∆P = $3$2, ∆ Qd = 3 unit 4 units
Ed = %∆ Qd / %∆P
= (∆ Qd / Average Qd ) / (∆P / Average P)
= [(4-3) / ((4+3)/2)] / [(3-2) / ((3+2)/2)]
= (1/3.5) / (1/2.5) = 0.714

Slope of demand curve = 1
Ed ≠Slope of demand curve?

Price elasticity of demand

If ∆P = $2$1, ∆ Qd = 4 unit 5 units
Ed = %∆ Qd / %∆P
= (∆ Qd / Average Qd ) / (∆P / Average P)
= [(5-4) / ((5+4)/2)] / [(2-1) / ((2+1)/2)]
= (1/4.5) / (1/1.5) = 0.33

Slope of demand curve = 1
Ed ≠Slope of demand curve?

Price elasticity of demand
P ($)
Ed > 1
Ed = 1
Ed < 1
0
Q
5 Types of elasticity of demand

Elastic demand



Elasticity is greater than 1 (Ed > 1)
Percentage change in quantity demanded is greater than
percentage change in price (%∆ Qd > %∆P)
Example

Toys
P ($)
D
0
Q
5 Types of elasticity of demand

Inelastic demand



Elasticity is smaller than 1 (Ed < 1)
Percentage change in quantity demanded is smaller than
percentage change in price (%∆ Qd < %∆P)
Example

Transportation
P ($)
D
0
Q
5 Types of elasticity of demand

Unitary elastic demand


Elasticity equals 1 (Ed = 1)
Percentage change in quantity demanded equals the
percentage change in price (%∆ Qd = %∆P)
P ($)
0
D (regular hyperbola)
Q
5 Types of elasticity of demand

Perfectly elastic demand



Elasticity equals infinity (Ed = ∞)
A slightly rise in price will cause quantity demanded fall to 0.
i.e. %∆P
Example: Lucky draw ticket
P ($)
D (horizontal)
0
Q
5 Types of elasticity of demand

Perfectly inelastic demand



Elasticity equals 0 (Ed = 0)
Price change has no effect on the quantity
demanded. (i.e. %∆Qd = 0)
Example: HKID card
P ($)
D (vertical)
0
Q
Factors affecting price
elasticity of demand
Substitutes
Quantity
More
substitutes  Easier to be replaced  Price elasticity 
E.g.
MTR started operation  Ed of bus service 
(MTR South Island Line)
When 3DTV launched  Ed of TV sets 
Technology of recycled energy   Ed of traditional energy sources 
When
Factors affecting price
elasticity of demand
Substitutes
Substitutability
Similar
goods have high substitutability
Higher substitutability  Price elasticity
E.g.
and soft drinks: Many brands  Ed 
Laptop (similar function): Many brands  Ed 
Bank services: Many banks in the market  Ed 
MTR service: Less choice  Ed
University programmes: A few choice only  Ed
Snacks
Factors affecting price
elasticity of demand
What
one has higher price elasticity of demand,
hamburger or water? Why?
Hamburger
is more elastic
a kind of food more substitutes  Ed 
as a brand  many other brands  Ed 
as
Water
is not elastic
a kind of element (functional): no close substitutes  Ed
as a brand  comparatively less brands  Ed is not high
as
Factors affecting price
elasticity of demand
The
1.


2.



way of determining a good
Salt
As an element (NaCl) :
No close substitute  Very inelastic
As different brands, e.g. Taikoo Salt, First choice, No frills:
Many brands  Very elastic
Water
As an element(H2O) :
No close substitute  Very inelastic
As different brands, e.g. Watsons, Bonaqua, Vita
Many brands  Very elastic
As different packages, e.g. 500mL, 1L, 2L, 5L, 10L, 1Lx6
Many packages  Very elastic
Factors affecting price
elasticity of demand
Types
Necessities
price elasticity, Price  Less change in Qd
E.g. electricity, tap water, public transports
Lower
Luxuries
price elasticity, Price  Greater response in Qd
E.g. visiting Disneyland, travelling overseas
Higher
Think
about:
Go to school
Dating
Wedding
Wedding

banquet
Fish fin
Factors affecting price
elasticity of demand
Time
time after ∆P
Easier to find substitutes Ed  Less change in Qd
E.g.
1. Price of oil 
 People take time to develop new technology
 More substitutes
 Less relying on oil
 Ed 
2. Price of washing powder 
 Shortly, no close substitutes  Low Ed
 People take time to develop new technology: washing ball
 No need to use washing powder
 Ed of washing powder
Longer
Factors affecting price
elasticity of demand
Exceptional
Case
cases
of Cross-Harbour Tunnel (1984, Dr. T.D.Hau)
Toll
 Usage 15% , shift to vehicle ferry
 Inconvenient, and no way to find substitutes
 Go back to 98% of normal usage before P
Case
of Cross-Harbour Tunnel (Now)
Toll
 Usage , shift to Eastern and Western Harbour Tunnels
 Time cost (Inconvenient) + higher tolls (EHT & WHT)
 Go back to similar usage before P
Factors affecting price
elasticity of demand
Proportion
of income spent on good
proportion  More inelastic
Large proportion  More elastic
Small
Soy sauce
Travelling
Monthly expenditure
$10
$600
Expenditure after P by 10% (Qd unchanged)
$11
$660
Additional expenditure
$1
$60
Incentive to find substitute
Low
High
Therefore, price elasticity is…
Low
High
Factors affecting price
elasticity of demand

Question (p.84)
Suppose the cost of finding substitutes for soy sauce and
bus service are both $5. Explain whether you would find
substitute for them.
Answer:
The benefit of finding substitutes for soy sauce is low
relative to the cost. Therefore, consumers may not find
substitutes for it.
However, for bus service, the benefit is relatively high
when compared to the cost, consumers may search for its
substitutes.
Relationship between Ed and
total revenue


Total revenue (R)
= Total expenditure
= Total market value
= Price x Quantity transacted
=PxQ
E.g. PA = $10 per unit, Q = 50 units
Total revenue of Good A = $10 x 50 = $500
Elasticity and change of total revenue
1.





Elastic demand and revenue
Rise in price
At P1 and Q1: R = P1xQ1 = Area (A+B)
When P (from P1 to P2), Q (from Q1 to Q2)
R = P2xQ2 = Area (A+C)
Loss (Area B) > Gain (Area C)
R
P ($)



Elastic (Ed>1):
%∆Qd > %∆P
R () = P() x Q()
P2
P1
C
gain
D
more
B
Loss
A
0
Q
Q2
Q1
Elasticity and change of total revenue
1.





Elastic demand and revenue
Fall in price
At P1 and Q1: R = P1xQ1 = Area (A+C)
When P (from P1 to P2), Q  (from Q1 to Q2)
R = P2xQ2 = Area (A+B)
Gain (Area B) > Loss (Area C)
R
P ($)



Elastic (Ed>1):
%∆Qd > %∆P
R () = P () x Q()
more
P1
P2
C
Loss
D
B
Gain
A
0
Q
Q1
Q2
Elasticity and change of total revenue
2.





Inelastic demand and revenue
Rise in price
At P1 and Q1: R = P1xQ1 = Area (A+B)
When P (from P1 to P2), Q (from Q1 to Q2)
R = P2x Q2 = Area (A+C)
Loss (Area B) < Gain (Area C)
R
P ($)



Elastic (Ed<1):
%∆Qd < %∆P
R () = P() x Q()
P2
C
gain
P1
more
A
0
B
Loss
D
Q2 Q1
Q
Elasticity and change of total revenue
2.





Inelastic demand and revenue
Fall in price
At P1 and Q1: R = P1xQ1 = Area (A+C)
When P  (from P1 to P2), Q  (from Q1 to Q2)
R = P2 x Q2 = Area (A+B)
Gain (Area B) < Loss (Area C)
R
P ($)



Elastic (Ed<1):
%∆Qd < %∆P
R () = P () x Q()
more
P1
C
Loss
P2
A
0
B
Gain
D
Q1 Q2
Q
Elasticity and change of total revenue
3.








Unitary elastic demand and revenue
Rise in price
At P1 and Q1: R = P1xQ1 = Area (A+B)
When P (from P1 to P2), Q (from Q1 to Q2)
R = P2x Q2 = Area (A+C)
Loss (Area B) = Gain (Area C)
R remains unchanged
P ($)
Elastic (Ed=1):
%∆Qd = %∆P
R (remains unchanged) = P() x Q()
P2
P1
C
gain
more
B
Loss
A
0
Q2
Q1
Q
Summary
∆P vs. ∆Revenue
Elastic demand
P  R 
P  R 
Inelastic demand
P  R 
P  R 
Unitary elastic demand
P 
R remains unchanged


Reason
%∆Qd > %∆P
%∆Qd < %∆P
%∆Qd = %∆P
Question (p.90)
Pam’s monthly expenditure on apples remains unchanged after a
rise in price. What is the elasticity of demand of apples? Explain. (3)
Answer:
Unitary elastic. Expenditure = Price x Quantity. Since her
expenditure on apples remains unchanged, the percentage increase
in price equals the percentage decrease in quantity demanded. So it
is unitary elastic demand.
MC question
What can the elasticity of demand of Good X be if its revenue drops
by 10% when its price rises by 5%?
A. 0.5
B. 1
C. 5
D. Infinity
Effects on change in supply
Supply curve shifts
1. Increase in supply  P & Q
a.
b.
c.
Elastic demand (Ed>1): P R
Unitary elastic demand (Ed=1): PR unchanged
Inelastic demand (Ed<1): PR
S1
P ($)
P1
P2
S2
C
Loss
D
B
Gain
A
0
Q
Q1
Q2
Effects on change in supply
Supply curve shifts
2. Decrease in supply  P & Q 
a.
b.
c.
Elastic demand (Ed>1): P  R
Unitary elastic demand (Ed=1): P R unchanged
Inelastic demand (Ed<1): P R 
S2
P ($)
P2
P1
S1
C
gain
D
B
Loss
A
0
Q
Q2
Q1
Effects on change in demand
Demand curve shifts
3. Increase in demand  P & Q 
a.
Elastic demand (Ed>1): R 
b.
Unitary elastic demand (Ed=1): R d
c.
Inelastic demand (Ed<1): R 
4. Decrease in demand  P & Q 
a.
Elastic demand (Ed>1): R 
b.
Unitary elastic demand (Ed=1): R 
c.
Inelastic demand (Ed<1): R 
P ($)
S
P2
P1
D2
D1
C
gain
0
Q1 Q2
Q
Price elasticity of supply



Measures the responsiveness of quantity supplied to a
change in price
Percentage change in quantity supplied over one percent
change in price
% ∆ QS
Ed = ---------%∆ P
Price elasticity of supply


Example (p.95)
Midpoint formula
150  100
50
%Qs 
x100% 
x100%  40%
(150  100) / 2
125
$12  $10
$2
%P 
x100% 
x100%  18.18%
($12  $10) / 2
$11
40%
Ed 
 2.2
18.18%
Price elasticity of supply


Example (p.95)
Midpoint formula
Qs
110  100
10
%Qs 
x100% 
x100% 
x100%  9.52%
Avg.Qs
(110  100) / 2
105
%P 
P
$525  $500
$25
x100% 
x100% 
x100%  4.88%
Avg.P
($525  $500) / 2
$512.5
9.52%
Ed 
 1.95
4.88%
Price elasticity of supply


Example (p.95)
Taking the case of P
150  100
50
%Qs 
x100% 
x100%  50%
100
100
$12  $10
$2
%P 
x100% 
x100%  20%
$10
$10
Ed 
50%
 2.5
20%
Price elasticity of supply


Example (p.95)
Midpoint formula
%Qs 
150  100
50
x100% 
x100%  40%
(150  100) / 2
125
$12  $10
$2
%P 
x100% 
x100%  18.18%
($12  $10) / 2
$11
Ed 
40%
 2.2
18.18%
5 Types of elasticity of supply
P ($)

Elastic supply


S
Elasticity is greater than 1 (Es > 1)
%∆ Qs > %∆P
Q
0

Inelastic supply


P ($)
Elasticity is smaller than 1 (Es < 1)
%∆ Qs < %∆P
S
0
Q
5 Types of elasticity of supply

Unitary elastic supply


Elasticity equals 1 (Ed = 1)
%∆ Qs = %∆P
P ($)
S
0
Q
5 Types of elasticity of supply

Perfectly elastic supply


Elasticity equals infinity (Ed = ∞)
A slightly rise in price will cause quantity supplied fall to 0. i.e.
%∆P
P ($)
S (horizontal)
0
Q
5 Types of elasticity of supply

Perfectly inelastic supply


Elasticity equals 0 (Ed = 0)
Price change has no effect on the quantity supplied.
(i.e. %∆Qs = 0)
P ($)
S (vertical)
0
Q
Factors affecting price
elasticity of supply
1. Factors of production
a. Values of factors of production different uses
Products
required non-specialized factors  Price elasticity 
E.g.
 Garment

 Qs 
 no need to hire many factors
 non-specialized factors (e.g. low-skilled workers) leave the product and go to another industry
 Greater fall in Qs
P
Products
required specialized factors  Price elasticity 
 Medical
service (factor: equipment)
 P  temporary, no increase in equipment because too specialized
 Qs has less effect on price change
Or
Demand 
P
 Existing equipment can’t be used for other purposes
 Change of Qs has less response
Factors affecting price
elasticity of supply
1. Factors of production
b. Adjustment cost of the cost of production
Production
E.g.
with non-specialized factors  Es 
Clerk, easier to hire when needed
Production
University
with specialized factors  Es 
principal, need to go through many procedures
Factors affecting price
elasticity of supply
Factors of production
1.
Availability of information
c.

More information  Es 
Reserve capacity of equipment
d.

More reserve  Es 
Idle resources in the economy
e.

More resources  Es 
Occupational/Geographical Mobility
f.

Higher mobility  Es 
Factors affecting price
elasticity of supply
Nature of products
2.
Easily perishable  Es 


3.
E.g. flowers at flower market: worthless if unsold
Market structure and entry barrier
 Restriction on output  Es 
How to restrict?




Entry barrier (e.g. registration is needed to become a doctor)
Monopoly (e.g. water supply)
Quota on imported goods
Factors affecting price
elasticity of supply
4. Time
Long the time  Es 



More time to hire/release factors of production
When P 
 High cost to increase output shortly
 Longer the time, more firms join the market, output 
P ($)
0
S1
S2
Q
Cases of perfectly inelastic
supply
1. Output limitation
Qs cannot be increases shortly

E.g.




Cross Harbour Tunnel at peak hours
Public Hospital (esp. maternity services) in HK
Application of China Visa
0
Q
Cases of perfectly inelastic
supply
Output limitation
1.


Qs cannot be increases shortly
E.g.



Cross Harbour Tunnel at peak hours
Public Hospital (esp. maternity services) in HK
Application of China Visa
Goods or services of non-profit making bodies
2.


Qs cannot be changed in accordance to price change
E.g.



Public housing (gov’t policy)
Police service
Social welfare service by NGO
Cases of perfectly inelastic
supply
3. Government control
Quotas

E.g.



Taxi license
Broadcasting license
4. Land supply


Qs is fixed
In terms of natural resources, but not the ownership of
a piece of land by the gov’t