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 

Given Qd (unit /day) 1. When price , Qd ? Qd of toy car  Doll Qd (unit /day) $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 Toy Car Doll Qd (unit /day, P=$100) 100 20 Qd (unit /day, P=$90) 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 Ed > 1 Ed = 1 Ed < 1 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 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 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 ($) 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) 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) Q

Factors affecting price elasticity of demand Substitutes Quantity 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 

Factors affecting price elasticity of demand Substitutes Substitutability Similar goods have high substitutability Higher substitutability  Price elasticity E.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  Ed University programmes: A few choice only  Ed

Factors affecting price elasticity of demand What one has higher price elasticity of demand, hamburger or water? Why? Hamburger is more elastic as a kind of food more substitutes  Ed  as a brand  many other brands  Ed  Water is not elastic as a kind of element (functional): no close substitutes  Ed as a brand  comparatively less brands  Ed is not high

Factors affecting price elasticity of demand The way of determining a good 1. 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) : As different brands, e.g. Watsons, Bonaqua, Vita As different packages, e.g. 500mL, 1L, 2L, 5L, 10L, 1Lx6 Many packages  Very elastic

Factors affecting price elasticity of demand Types Necessities Lower price elasticity, Price  Less change in Qd E.g. electricity, tap water, public transports Luxuries Higher price elasticity, Price  Greater response in Qd E.g. visiting Disneyland, travelling overseas Think about: Go to school Dating Wedding Wedding banquet Fish fin

Factors affecting price elasticity of demand Time Longer 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

Factors affecting price elasticity of demand Exceptional cases Case 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)  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 Small proportion  More inelastic Large 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…

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 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  Elastic (Ed>1): %∆Qd > %∆P R () = P() x Q() D P ($) Q C gain B Loss A P2 P1 Q1 Q2 more

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  Elastic (Ed>1): %∆Qd > %∆P R () = P () x Q() P ($) P1 C Loss P2 D more B Gain A 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  Elastic (Ed<1): %∆Qd < %∆P R () = P() x Q() P ($) P2 C gain P1 more B Loss A D Q Q2 Q1

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  Elastic (Ed<1): %∆Qd < %∆P R () = P () x Q() P ($) P1 C Loss P2 more B Gain A D Q Q1 Q2

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 Elastic (Ed=1): %∆Qd = %∆P R (remains unchanged) = P() x Q() P ($) P2 C gain P1 more A B Loss Q Q2 Q1

Unitary elastic demand Summary ∆P vs. ∆Revenue Reason Elastic demand P  R  P  R  %∆Qd > %∆P Inelastic demand P  R  P  R  %∆Qd < %∆P Unitary elastic demand P  R remains unchanged %∆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 Elastic demand (Ed>1): P R Unitary elastic demand (Ed=1): PR unchanged Inelastic demand (Ed<1): PR S1 P ($) S2 P1 C Loss P2 D B Gain A Q Q1 Q2

Effects on change in supply Supply curve shifts 2. Decrease in supply  P & Q  Elastic demand (Ed>1): P  R Unitary elastic demand (Ed=1): P R unchanged Inelastic demand (Ed<1): P R  S2 P ($) S1 P2 C gain P1 D B Loss A Q Q2 Q1

Effects on change in demand Demand curve shifts 3. Increase in demand  P & Q  Elastic demand (Ed>1): R  Unitary elastic demand (Ed=1): R d Inelastic demand (Ed<1): R  4. Decrease in demand  P & Q  Elastic demand (Ed>1): R  Unitary elastic demand (Ed=1): R  Inelastic demand (Ed<1): R  P ($) S P2 D2 C gain P1 D1 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

Price elasticity of supply Example (p.95) Midpoint formula

Price elasticity of supply Example (p.95) Taking the case of P

Price elasticity of supply Example (p.95) Midpoint formula

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 Q P ($) S Q

5 Types of elasticity of supply Unitary elastic supply Elasticity equals 1 (Ed = 1) %∆ Qs = %∆P P ($) S 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) 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) 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 P   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 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 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

Factors affecting price elasticity of supply Factors of production Availability of information More information  Es  Reserve capacity of equipment More reserve  Es  Idle resources in the economy More resources  Es  Occupational/Geographical Mobility Higher mobility  Es 

Factors affecting price elasticity of supply Nature of products Easily perishable  Es  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 ($) 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 Q

Cases of perfectly inelastic supply 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 Goods or services of non-profit making bodies Qs cannot be changed in accordance to price change 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