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1 4.Elasticity of Demand and Supply

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2 Chapter 4 : main menu 4.1Price elasticity of demandConcept Explorer 4.1 Progress Checkpoint 1 Concept Explorer 4.2 Theory in Life 4.1 Theory in Life 4.2 Progress Checkpoint 2 4.2Price elasticity of supplyTheory in Life 4.3 Theory in Life 4.4 Progress Checkpoint 3

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3 Concept Explorer 4.1 u For a straight and downward sloping demand curve, its price elasticity of demand is different at different price ranges. 0 Ed > 1 (above mid-point) Ed < 1 (below mid-point) Ed = 1 (at mid-point) Quantity P ($) D

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4 u 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. Progress Checkpoint 1

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5 Concept Explorer 4.2 u 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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6 Concept Explorer 4.2 u 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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7 Theory in Life 4.1 u 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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8 Theory in Life 4.1 u When the price of mobile phone service decreases from P1 to P2, the quantity demanded increases from Q1 to Q2. u If the demand is elastic (Ed > 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. u There will be a net increase in total revenue. loss Quantity 0Q1Q2 P1 P2 D gain Price ($)

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9 Theory in Life 4.1 u When the price of residential phone service increases from P1 to P2, the quantity demanded decreases from Q1 to Q2. u If the demand is inelastic (Ed < 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. u There will be a net increase in total revenue. Quantity 0 Price ($) lossloss Q1Q2 P1 P2 D gain

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10 Theory in Life 4.2 u 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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11 Theory in Life 4.2 u When the mini-bus fare is at P1, the quantity demanded Qd1 is greater than the quantity supplied Qs1. u The shortage is marked ED1 which implies queue for mini-bus service. u Since the quantity transacted is at Qs1, the total expenditure spent on mini- bus service is P1 x Qs1. Quantity 0 S D Price ($) P1 P2 Qs1Qs2Qd2Qd1 ED1 ED2 gain

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12 Theory in Life 4.2 u When the fare is increased to P2, quantity demanded decreases to Qd2 while quantity supplied increases to Qs2. u The shortage is reduced to ED2 which implies a shorter queue. u Since quantity transacted increases to Qs2, the total expenditure increases to P2 x Qs2. Quantity 0 S D Price ($) P1 P2 Qs1Qs2Qd2Qd1 gain ED1 ED2

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13 Progress Checkpoint 2 u 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. u The supermarket recently reduced the price of rice and raised the price of apple. u Can these changes increase the total revenue of the supermarket? Use well-labelled supply-demand diagrams to support your views.

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14 Progress Checkpoint 2 u If the price of rice decreases from P1 to P2, quantity demanded will increase from Q1 to Q2. u The demand for rice is inelastic, i.e. Ed < 1, or the percentage change in quantity demanded is less than the percentage change in price. gaingain 0Q2Q1 P2 P1 D loss Price ($) Quantity

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15 Progress Checkpoint 2 u Therefore the gain in revenue will be less than the loss. u This leads to a net decrease in total revenue. u Such decrease in price cannot increase the total revenue of the supermarket. gaingain 0Q2Q1 P2 P1 D loss Price ($) Quantity

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16 Progress Checkpoint 2 u If the price of apple increases from P1 to P2, quantity demanded decreases from Q1 to Q2. u The demand for apple is elastic, i.e. Ed > 1, or the percentage change in quantity demanded is greater than the percentage change in price. Quantity 0 Price ($) gain Q2Q1 P2 P1 D loss

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17 Progress Checkpoint 2 u Therefore the gain in revenue will be less than the loss. u This leads to a net decrease in total revenue. u Such increase in price cannot increase the total revenue of the supermarket. Quantity 0 Price ($) gain Q2Q1 P2 P1 D loss

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18 Progress Checkpoint 2 u 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. u 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. gain Quantity0Q1Q2 P D1 Price ($) D2

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19 Theory in Life 4.3 u Suppose the ticket price of a concert is set below equilibrium level. u As a result, there are insufficient tickets to satisfy the demand. u How will total revenue change if the ticket price is adjusted to the equilibrium level?

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20 Theory in Life 4.3 u As there is a maximum capacity of seats in a concert, the supply of concert ticket is perfectly inelastic. u The ticket price is initially set at P1. u As quantity demanded at Qd is greater than quantity supplied or quantity transacted at Qt, shortage exists. Total revenue is P1 x Qt. gain Quantity0 P1 P2 QtQd D S Price ($) shortage

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21 gain Theory in Life 4.3 u If the ticket price increases to P2, quantity transacted remains constant at Qt. u The market is now in equilibrium, and total revenue is P2 x Qt, i.e. increases by the shaded area. Quantity0 P1 P2 QtQd D S Price ($) shortage

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22 Theory in Life 4.4 u 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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23 Theory in Life 4.4 u 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. u 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. Quantity 0 D1 D2 Price ($) gain QsQd1Qd2 P ES2 ES1 S

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24 Theory in Life 4.4 u 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. u When demand increases from D1 to D2, the surplus decreases to ES2, implying an increase in the utilization of the tunnel. u Total revenue also increases to P x Qd2, i.e. increases by the shaded area. Quantity 0 D1 D2 Price ($) gain QsQd1Qd2 P ES2 ES1 S

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25 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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26 Progress Checkpoint 3 (a) (b) (c) The quantity supplied increases by 4.13%. The price decreases by 2.86%.

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27 Progress Checkpoint 3 u 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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28 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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29 End of Chapter 4

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