Economics Chapter 10 Price elasticity of Demand and Supply

Economics

Chapter 10

Price elasticity of

Demand and Supply

Law of demand

∆P ∆Qd , ceteris paribus* P Qd or P Qd

P ($)

Q

Given

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 Toy Car Doll

Qd (unit /day) $100 100 20

Qd (unit /day) $90 110 40

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


Example (p.75) When P


Example (p.76) When P


Example (p.76) Midpoint formula


Calculate Ed of toy car and doll when Prices drop Prices rise By using midpoint formula

Toy Car Doll

Qd (unit /day, P=$100) 100 20

Qd (unit /day, P=$90) 110 40


Given a straight line demand curve :Slope of demand curve = 6-0 / 0-6 = -1Slope = 1, with negative relationship between P and Qd

Price elasticity:If ∆P = $6$0,

∆ Qd = 0 unit 6 unitsEd = %∆ 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?


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?



Ed = %∆ Qd / %∆P


= [(3-2) / ((3+2)/2)] / [(4-3) / ((4+3)/2)]

= (1/2.5) / (1/3.5) = 1.4




Ed = %∆ Qd / %∆P


= [(4-3) / ((4+3)/2)] / [(3-2) / ((3+2)/2)]

= (1/3.5) / (1/2.5) = 0.714




Ed = %∆ Qd / %∆P


= [(5-4) / ((5+4)/2)] / [(2-1) / ((2+1)/2)]

= (1/4.5) / (1/1.5) = 0.33



P ($)

Q

Ed < 1

Ed > 1Ed = 1

0

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

D

P ($)

Q0


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

D

P ($)

Q0


Unitary elastic demand Elasticity equals 1 (Ed = 1) Percentage change in quantity demanded equals the

percentage change in price (%∆ Qd = %∆P)

D (regular hyperbola)

P ($)

Q0


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

D (horizontal)

P ($)

Q0


Perfectly inelastic demand Elasticity equals 0 (Ed = 0) Price change has no effect on the quantity

demanded. (i.e. %∆Qd = 0) Example: HKID card

D (vertical)

P ($)

Q0

Factors affecting price elasticity of demand

SubstitutesQuantity

More substitutes Easier to be replaced Price elasticity E.g.

When 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


SubstitutesSubstitutability

Similar goods have high substitutabilityHigher substitutability Price elasticityE.g.

Snacks and soft drinks: Many brands Ed Laptop (similar function): Many brands Ed Bank services: Many banks in the market Ed MTR service: Less choice EdUniversity programmes: A few choice only Ed


What one has higher price elasticity of demand, hamburger or water? Why?

Hamburger is more elasticas a kind of food more substitutes Ed as a brand many other brands Ed

Water is not elasticas a kind of element (functional): no close substitutes Edas a brand comparatively less brands Ed is not high


The way of determining a good1. 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

2. 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


TypesNecessities

Lower price elasticity, Price Less change in QdE.g. electricity, tap water, public transports

LuxuriesHigher price elasticity, Price Greater response in Qd E.g. visiting Disneyland, travelling overseas

Think about: Go to schoolDatingWedding

Wedding banquet Fish fin


TimeLonger 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


Exceptional casesCase 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 PCase 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


Proportion of income spent on goodSmall proportion More inelasticLarge proportion More elastic

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

= P x Q 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 revenueRise 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

Elastic (Ed>1): %∆Qd > %∆P R () = P() x Q()

D

P ($)

Q0

Cgain

BLossA

P2

P1

Q1Q2

more


1. Elastic demand and revenueFall 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

Elastic (Ed>1): %∆Qd > %∆P R () = P () x Q()

D

P ($)

Q0

CLoss

BGainA

P2

P1

Q2Q1

more


2. Inelastic demand and revenueRise 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

Elastic (Ed<1): %∆Qd < %∆P R () = P() x Q()

D

P ($)

Q0

Cgain

BLossA

P2

P1

Q1Q2

more


2. Inelastic demand and revenueFall 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

Elastic (Ed<1): %∆Qd < %∆P R () = P () x Q()

more

D

P ($)

Q0

CLoss

BGainA

P1

P2

Q2Q1


3. Unitary elastic demand and revenueRise 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

Elastic (Ed=1): %∆Qd = %∆P R (remains unchanged) = P() x Q()

0

Cgain

BLossA

P2

P1

Q1Q2

more

P ($)

Q

Summary

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 questionWhat 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

∆P vs. ∆Revenue Reason

Elastic demandP R P R

%∆Qd > %∆P

Inelastic demandP R P R

%∆Qd < %∆P

Unitary elastic demandP

R remains unchanged%∆Qd = %∆P

Effects on change in supply

Supply curve shifts1. Increase in supply P & Q

a. Elastic demand (Ed>1): P Rb. Unitary elastic demand (Ed=1): PR unchangedc. Inelastic demand (Ed<1): PR

D

P ($)

Q0

CLoss

BGainA

P1

P2

Q2Q1

S2

S1

Effects on change in supply

Supply curve shifts2. Decrease in supply P & Q

a. Elastic demand (Ed>1): P Rb. Unitary elastic demand (Ed=1): P R unchangedc. Inelastic demand (Ed<1): P R

D

P ($)

Q0

Cgain

BLossA

P2

P1

Q1Q2

S1

S2

Effects on change in demand

Demand curve shifts3. Increase in demand P & Q

a. Elastic demand (Ed>1): R b. Unitary elastic demand (Ed=1): R dc. 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

D1

P ($)

Q0

Cgain

P2

P1

Q1 Q2

D2

S

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



%40%100125

50%100

2/)100150(

100150%

xxQs

%18.18%10011$

2$%100

2/)10$12($

10$12$%

xxP

2.2%18.18

%40Ed



%52.9%100105

10%100

2/)100110(

100110%100

.%

xxxQsAvg

QsQs

%88.4%1005.512$

25$%100

2/)500$525($

500$525$%100

.%

xxxPAvg

PP

95.1%88.4

%52.9Ed


Example (p.95) Taking the case of P

%50%100100

50%100

100

100150%

xxQs

%20%10010$

2$%100

10$

10$12$%

xxP

5.2%20

%50Ed



%40%100125

50%100

2/)100150(

100150%

xxQs

%18.18%10011$

2$%100

2/)10$12($

10$12$%

xxP

2.2%18.18

%40Ed

5 Types of elasticity of supply

Elastic supply Elasticity is greater than 1 (Es > 1) %∆ Qs > %∆P

Inelastic supply Elasticity is smaller than 1 (Es < 1) %∆ Qs < %∆P

S

P ($)

Q0

S

P ($)

Q0


Unitary elastic supply Elasticity equals 1 (Ed = 1) %∆ Qs = %∆P

SP ($)

Q0


Perfectly elastic supply Elasticity equals infinity (Ed = ∞) A slightly rise in price will cause quantity supplied fall to 0.

i.e. %∆P

S (horizontal)

P ($)

Q0


Perfectly inelastic supply Elasticity equals 0 (Ed = 0) Price change has no effect on the quantity

supplied. (i.e. %∆Qs = 0)

S (vertical)

P ($)

Q0

Factors affecting price elasticity of supply

1. Factors of productiona. Values of factors of production different uses

Products required non-specialized factors Price elasticity E.g.

GarmentP 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

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 changeOr Demand

P Existing equipment can’t be used for other purposes Change of Qs has less response


1. Factors of productionb. Adjustment cost of the cost of production

Production with non-specialized factors Es E.g. Clerk, easier to hire when needed

Production with specialized factors Es University principal, need to go through many procedures


1. Factors of productionc. Availability of information

More information Es

d. Reserve capacity of equipment More reserve Es

e. Idle resources in the economy More resources Es

f. Occupational/Geographical Mobility Higher mobility Es


2. Nature of products Easily perishable Es

E.g. flowers at flower market: worthless if unsold

3. 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


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

S1P ($)

Q0

S2

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

Q0


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

2. Goods or services of non-profit making bodies Qs cannot be changed in accordance to price change

E.g. Public housing (gov’t policy) Police service Social welfare service by NGO


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

Documents

Economics Chapter 10 Price elasticity of Demand and Supply