CHAPTER 3 ► ELASTICITY OF DEMAND AND SUPPLY 40 ELASTICITY OF DEMAND AND SUPPLY CHAPTER MAP 1 INTRODUCTION 2 PRICE ELASTICITY OF DEMAND 2.1 Measurement and Interpretation of Price Elasticity of Demand 2.2 Applications of Price Elasticity of Demand 2.3 Determinants of Price Elasticity of Demand 3 INCOME ELASTICITY OF DEMAND 3.1 Measurement and Interpretation of Income Elasticity of Demand 3.2 Applications of Income Elasticity of Demand 3.3 Determinants of Income Elasticity of Demand 4 CROSS ELASTICITY OF DEMAND 4.1 Measurement and Interpretation of Cross Elasticity of Demand 4.2 Applications of Cross Elasticity of Demand 4.3 Determinants of Cross Elasticity of Demand 5 PRICE ELASTICITY OF SUPPLY 5.1 Measurement and Interpretation of Price Elasticity of Supply 5.2 Determinants of Price Elasticity of Supply 6 LIMITATIONS OF THE CONCEPTS OF ELASTICITY OF DEMAND 7 EFFECTS OF ELASTICITY ON PRICE AND QUANTITY 1 INTRODUCTION In Chapter 2, we learnt that a fall in price will lead to an increase in quantity demanded and vice versa. However, given any change in price, in addition to the direction of the change in quantity demanded, economists are interested to find the magnitude of the change. In other words, they are interested to find the degree of responsiveness of consumers to a change in price. To measure this, they use the concept of price elasticity of demand. Furthermore, economists are also interested to find the degree of responsiveness of consumers to a change in income and a change in the prices of related goods. To measure this, economists use the concepts of income elasticity of demand and cross elasticity of demand. This chapter provides an exposition of the concepts of price elasticity of demand, income elasticity of demand, cross elasticity of demand and price elasticity of supply.
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3 ELASTICITY OF DEMAND AND SUPPLY
CHAPTER MAP1 INTRODUCTION
2 PRICE ELASTICITY OF DEMAND2.1 Measurement and Interpretation of Price Elasticity of Demand
2.2 Applications of Price Elasticity of Demand
2.3 Determinants of Price Elasticity of Demand
3 INCOME ELASTICITY OF DEMAND3.1 Measurement and Interpretation of Income Elasticity of Demand
3.2 Applications of Income Elasticity of Demand
3.3 Determinants of Income Elasticity of Demand
4 CROSS ELASTICITY OF DEMAND4.1 Measurement and Interpretation of Cross Elasticity of Demand
4.2 Applications of Cross Elasticity of Demand
4.3 Determinants of Cross Elasticity of Demand
5 PRICE ELASTICITY OF SUPPLY5.1 Measurement and Interpretation of Price Elasticity of Supply
5.2 Determinants of Price Elasticity of Supply
6 LIMITATIONS OF THE CONCEPTS OF ELASTICITY OF DEMAND
7 EFFECTS OF ELASTICITY ON PRICE AND QUANTITY
1 INTRODUCTION
In Chapter 2, we learnt that a fall in price will lead to an increase in quantity demanded and vice versa. However, given any change in price, in addition to the direction of the change in quantity demanded, economists are interested to find the magnitude of the change. In other words, they are interested to find the degree of responsiveness of consumers to a change in price. To measure this, they use the concept of price elasticity of demand. Furthermore, economists are also interested to find the degree of responsiveness of consumers to a change in income and a change in the prices of related goods. To measure this, economists use the concepts of income elasticity of demand and cross elasticity of demand. This chapter provides an exposition of the concepts of price elasticity of demand, income elasticity of demand, cross elasticity of demand and price elasticity of supply.
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2 PRICE ELASTICITY OF DEMAND
2.1 Measurement and Interpretation of Price Elasticity of Demand
The price elasticity of demand (PED) for a good is a measure of the degree of responsiveness of the quantity demanded to a change in the price, ceteris paribus.
The PED for a good is calculated by dividing the percentage change in the quantity demanded by the percentage change in the price.
Due to the law of demand, the PED for a good is always negative. However, the common practice among economists is to omit the negative sign.
If the PED for a good is greater than one, the demand is price elastic which means that a change in the price will lead to a larger percentage/proportionate change in the quantity demanded. A good with a price elastic demand has a relatively flat demand curve. If the PED for a good is less than one, the demand is price inelastic which means that a change in the price will lead to a smaller percentage/proportionate change in the quantity demanded. A good with a price inelastic demand has a relatively steep demand curve. If the PED for a good is equal to one, the demand is unit price elastic which means that a change in the price will lead to the same percentage/proportionate change in the quantity demanded. The demand curve for a good with a unit price elastic demand is a rectangular hyperbola.
Special Cases: If the PED for a good is zero, the demand is perfectly price inelastic which means that a change in the price will not lead to any change in the quantity demanded. A good with a perfectly price inelastic demand has a vertical demand curve. If the PED for a good is infinity, the demand is perfectly price elastic which means that a rise in the price will lead to an infinite decrease in the quantity demanded. In theory, this means that the quantity demanded will fall from infinity to zero. A good with a perfectly price elastic demand has a horizontal demand curve.
Note: It is important to understand that the concept of elasticity is about relative changes and not about absolute changes. this is because although price is measured in dollars, quantity demanded is measured in units. Due to the difference in the units of measurement, we can only compare the changes in price and quantity demanded in relative terms. For example, it is wrong to say, ‘If demand is price elastic, a fall in price will lead to a large increase in quantity demanded.’. the correct way to say it is, ‘If demand is price elastic, a fall in price will lead to a larger percentage/proportionate increase in quantity demanded.’. Students should not confuse relative changes with absolute changes.
2.2 Applications of Price Elasticity of Demand
The concept of PED allows a firm to determine how to change price to increase total revenue.
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If the demand for the good produced by a firm is price elastic, the firm can decrease the price to increase total revenue as the quantity demanded will increase by a larger percentage.
In the above diagram, the initial total revenue is area A plus area B and the new total revenue is area B plus area C. Area C is the gain in revenue resulting from the increase in the quantity demanded (Q) from Q0 to Q1 and area A is the loss in revenue resulting from the fall in the price (P) from P0 to P1. Since area C is greater than area A, the gain exceeds the loss and hence the total revenue rises.
If the demand for the good produced by a firm is price inelastic, the firm can increase the price to increase total revenue as the quantity demanded will decrease by a smaller percentage.
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In the above diagram, the initial total revenue is area B plus area C and the new total revenue is area A plus area B. Area A is the gain in revenue resulting from the rise in the price (P) from P0 to P1 and area C is the loss in revenue resulting from the decrease in the quantity demanded (Q) from Q0 to Q1. Since area A is greater than area C, the gain exceeds the loss and hence the total revenue rises.
If the demand for the good produced by a firm is unit price elastic, the firm cannot change the price to increase total revenue as the quantity demanded will change by the same percentage.
In addition to firms, the concept of price elasticity of demand may be useful to the government. The main source of revenue for the government is tax revenue. If the government imposes a tax on a good, the cost of production will rise which will lead to a decrease in the supply. When this happens, the price will rise which will lead to a fall in the quantity demanded. If the demand for the good is price elastic, the quantity demanded is likely to fall by a large extent. As the tax revenue is the product of the tax per unit of the good and the quantity, a large decrease in the quantity demanded is likely to limit the amount of tax revenue which the government can collect. Therefore, if the government wants to collect a large amount of tax revenue from imposing taxes on goods, it should do so for goods with a price inelastic demand. Examples of goods with a price inelastic demand include tobacco and alcohol due to their addictive nature. The government may also impose taxes on goods to reduce the consumption. These are generally goods which society deems undesirable and the government thinks people should be discouraged to consume, commonly known as demerit goods. Examples of demerit goods include tobacco and alcohol. However, due to the addictive nature of tobacco and alcohol which makes the demand price inelastic, the government should ensure that the taxes are sufficiently large to reduce the consumption to the desired levels.
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Note: When we are discussing the effects of a tax on a good on the consumption or tax revenue, it is wrong to say, ‘If the demand for the good is price elastic, the quantity demanded will fall by a larger percentage/proportion.’. the correct way to say it is, “If the demand for the good is price elastic, the quantity demanded will fall by a large extent.’. this is because we are not comparing the changes in the price and the quantity demanded.
Apart from the microeconomic level, price elasticity of demand can be useful to the government at the macroeconomic level. the usefulness of price elasticity of demand to the government at the macroeconomic level will be explained in greater detail in Chapter 13.
2.3 Determinants of Price Elasticity of Demand
Number of SubstitutesThe PED for a good will be higher the larger the number of substitutes. Conversely, the PED for a good will be lower the smaller the number of substitutes. For example, the demand for a brand of smartphones is likely to be price elastic due to the large number of substitute brands in the market such as Apple, Samsung, LG, HTC, Sony, BlackBerry, etc. The number of substitutes for a good depends, in part, on how narrowly, and for that matter, how broadly the good is defined. The more broadly a good is defined, the smaller the number of substitutes and hence the less price elastic the demand for the good. Conversely, the more narrowly a good is defined, the larger the number of substitutes and hence the more price elastic the demand for the good. For example, the demand for beef is more price elastic than the demand for food because, unlike food, there are substitutes for beef.
Closeness of SubstitutesThe PED for a good will be higher the closer the substitutes. Conversely, the PED for a good will be lower the further the substitutes. For example, the demand for residential properties is price inelastic due to lack of close substitutes, apart from the high degree of necessity. In contrast, the demand for the mobile network services provided by an operator in Singapore such as SingTel is likely to be price elastic due to the presence of close substitutes which include the mobile network services provided by other operators such as M1 and StarHub.
Degree of NecessityThe PED for a good will be higher the lower the degree of necessity. Conversely, the PED for a good will be lower the higher the degree of necessity. For example, the demand for oil is price inelastic due to the high degree of necessity, apart from lack of close substitutes.
Proportion of Income Spent on the GoodThe PED for a good will be higher the larger the proportion of income spent on the good. Conversely, the PED for a good will be lower the smaller the proportion of income spent on the good. For example, the demand for private cars is likely to be price elastic due to the large proportion of income spent on the goods as they are generally expensive. In contrast, the demand for stationery
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is likely to be price inelastic due to the small proportion of income spent on the good as it is generally cheap, apart from the high degree of necessity.
Time PeriodThe PED for a good will be higher the longer the time period under consideration. Conversely, the PED for a good will be lower the shorter the time period under consideration. This is because consumers need time to adjust their consumption patterns and find substitutes. For example, given any increase in the price of petrol, the quantity demanded will not fall significantly in the short run as people need to drive their cars. However, the quantity demanded will fall more significantly over time as more fuel-efficient cars can be developed and people can switch to smaller cars which consume less fuel.
Note: Students should avoid arguing that the demand for a good is likely to be price elastic due to the low degree of necessity. this is because saying this would suggest that the demand for most goods is likely to be price elastic as there are more non-essential goods than essential goods.
Students should avoid arguing that the demand for a good is likely to be price inelastic due to the small number of substitutes. this is because the substitutes for the good may be close which is likely to make the demand for the good price elastic.
3 INCOME ELASTICITY OF DEMAND
3.1 Measurement and Interpretation of Income Elasticity of Demand
The income elasticity of demand (YED) for a good is a measure of the degree of responsiveness of the demand to a change in income, ceteris paribus.
The YED for a good is calculated by dividing the percentage change in the demand by the percentage change in income.
If the YED for a good is positive, the good is a normal good. A normal good is a good whose demand rises when consumers’ income rises. There are two types of normal goods: necessity and luxury. A necessity is a normal good with a YED between zero and one. In other words, the demand for a necessity is income inelastic. An example of a necessity is agricultural products. A luxury is a normal good with a YED greater than one. In other words, the demand for a luxury is income elastic. An example of a luxury is private cars. If the YED for a good is negative, the good is an inferior good. An inferior good is a good whose demand falls when consumers’ income rises. An example of an inferior good is public transport.
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3.2 Applications of Income Elasticity of Demand
The concept of YED allows a firm to determine the future size of the market for the good and hence its production capacity. Suppose that the YED for a good is positive. If a firm predicts an economic expansion which is a period of time during which national income is rising, it should increase its production capacity in order to be able to meet the higher demand when the economic expansion comes. Furthermore, the higher the YED is, the larger will be the increase in the demand and hence the larger the extent the firm should increase its production capacity. Conversely, if the firm predicts an economic contraction which is a period of time during which national income is falling, it should decrease its production capacity to minimise excess capacity when the economic contraction comes.
The concept of YED may enable a firm to determine how to formulate its marketing strategy. Suppose that a firm sells two goods. Further suppose that one of the goods is a normal good and the other good is an inferior good. If the economy is expanding and hence national income is rising, the firm should focus its marketing strategy on the normal good. Conversely, if the economy is contracting and hence national income is falling, the firm should focus its marketing strategy on the inferior good.
Note: It is important to note that increasing production capacity is not the same as increasing production. Increasing production capacity does not lead to an increase in current output. Rather, it enables the firm to increase future output.
3.3 Determinants of Income Elasticity of Demand
Nature of the GoodThe YED for a good will be higher the more luxurious the good. Conversely, the YED for a good will be lower the less luxurious the good. For example, the YED for high-end private cars is higher than those for mid-range and low-end private cars as high-end private cars are more luxurious than mid-range and low-end private cars.
Level of IncomeThe YED for a good will be higher the lower the level of income. Conversely, the YED for a good will be lower the higher the level of income. For example, the YED for private cars in the Philippines is higher than that in Singapore as the level of income in the Philippines is lower than that in Singapore.
4 CROSS ELASTICITY OF DEMAND
4.1 Measurement and Interpretation of Cross Elasticity of Demand
The cross elasticity of demand (XED) for a good with respect to another good is a measure of the degree of responsiveness of the demand for the first good to a change in the price of the second good, ceteris paribus. Let the two goods be good A and good B.
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The XED for good A with respect to good B is calculated by dividing the percentage change in the demand for good A by the percentage change in the price of good B.
If XEDAB is positive, good A and good B are substitutes. Substitutes are goods which are consumed in place of one another such as Coke and Pepsi. If the price of good B rises, consumers will buy less of it. Since good A and good B are substitutes, they will buy more good A. If XEDAB is negative, good A and good B are complements. Complements are goods which are consumed in conjunction with one another such as car and petrol. If the price of good B rises, consumers will buy less of it. Since good A and good B are complements, they will buy less good A.
Note: Students should understand that the concept of XeD can be used to explain the effect of a change in the price of a related good on the demand for a good only when the change in the price of the related good is due to a movement along the demand curve.
4.2 Applications of Cross Elasticity of Demand
The concept of XED allows a firm to determine how a change in the price of a related good produced by another firm will affect the demand for its good. For example, if a rival firm decreases its price, the demand for the good produced by the first firm will fall due to the positive XED between substitutes. To avoid a decrease in sales, the firm may need to decrease its price. However, if this is likely to lead to a price war, the firm may consider engaging in non-price competition such as product promotion and product development instead of decreasing its price. If a rival firm increases its price, the demand for the good produced by the first firm will increase if it keeps its price constant. However, the firm may not experience an increase in sales if it has no or little excess capacity.
The concept of XED may enable a firm that produces two or more goods which are complements to increase total revenue. For example, a telecommunications firm may reduce the price of its mobile devices even if the demand is price inelastic. Although the revenue from the sale of its mobile devices will fall as the quantity demanded will rise by a smaller proportion, the demand and hence the revenue from the provision of its mobile network services will rise due to the negative XED between mobile network services and mobile devices. Therefore, the total revenue of the telecommunications firm may increase.
4.3 Determinants of Cross Elasticity of Demand
The XED between two goods will be higher the more closely they are related. For example, the XED between Coke and Pepsi is higher than that between coffee and tea as Coke and Pepsi are closer substitutes than coffee and tea are.
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5 PRICE ELASTICITY OF SUPPLY
5.1 Measurement and Interpretation of Price Elasticity of Supply
The price elasticity of supply (PES) of a good is a measure of the degree of responsiveness of the quantity supplied to a change in the price, ceteris paribus.
The PES of a good is calculated by dividing the percentage change in the quantity supplied by the percentage change in the price.
%ΔQuantitySupplied PES = ------------------------------------------------------------------------- %ΔPrice
Due to the law of supply, the PES of a good is always positive.
If the PES of a good is greater than one, the supply of the good is price elastic which means that a change in the price of the good will lead to a larger percentage/proportionate change in the quantity supplied. A good with a price elastic supply has a relatively flat supply curve. If the PES of a good is less than one, the supply of the good is price inelastic which means that a change in the price of the good will lead to a smaller percentage/proportionate change in the quantity supplied. A good with a price inelastic supply has a relatively steep supply curve. If the PES of a good is equal to one, the supply of the good is unit price elastic which means that a change in the price of the good will lead to the same percentage/proportionate change in the quantity supplied.
Special Cases: If the PES of a good is zero, the supply of the good is perfectly price inelastic which means that a change in the price of the good will not lead to any change in the quantity supplied. A good with a perfectly price inelastic supply has a vertical supply curve. If the PES of a good is infinity, the supply of the good is perfectly price elastic which means that a fall in the price of the good will lead to an infinite decrease in the quantity supplied. In theory, this means that the quantity supplied will fall from infinity to zero. A good with a perfectly price elastic supply has a horizontal supply curve.
5.2 Determinants of Price Elasticity of Supply
Production Time and ‘Stockability’ of the GoodWhen the price of a good rises, firms can increase the quantity supplied in two ways: increase production and draw from stock. Therefore, if the production time of a good is long and if it cannot be stocked in large quantities, the supply is likely to be price inelastic, and vice versa. The ‘stockability’ of a good depends on the size of the good and whether it is perishable. Goods that are small in size and non-perishable can be stocked in large quantities, and vice versa. For example, the production time of agricultural products is long due to the long gestation period and they cannot be stocked due to the perishable nature. Therefore, the supply of agricultural products is price inelastic. In contrast, the supply of manufactured goods is more price elastic as the production time is shorter and they generally can be stocked. The supply of luxuries is likely to be price inelastic as the production time is likely to be long because they are typically high quality
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goods that normally undergo stringent quality control. In contrast, the supply of necessities and inferior goods is likely to be price elastic as the production time is likely to be short due to the limited focus on the quality.
Excess CapacityGiven any increase in the price of a good, the lower the output level and hence the larger the amount of excess capacity, the slower the marginal cost of production will rise as firms increase output. The slower the marginal cost of production for a good rises as firms increase output in response to a rise in the price, the larger the increase in output. Therefore, the lower the output level of a good and hence the larger the amount of excess capacity, the more price elastic the supply of the good. Conversely, the higher the output level of a good and hence the smaller the amount of excess capacity, the less price elastic the supply of the good.
Definition of the GoodThe more broadly a good is defined, the less price elastic the supply. Conversely, the more narrowly a good is defined, the more price elastic the supply. For example, the supply of a crop is more price elastic than the supply of crops as a whole as it is easier to obtain factor inputs from within the agricultural sector to produce a crop than to obtain factor inputs from other industries to produce crops as a whole.
Time PeriodThe longer the time period after an increase in the price of a good, the more price elastic the supply of the good as firms are able to increase the production by a larger amount with more time. Time period can be divided into the immediate run, the short run and the long run. The immediate run is the time period that is so short that the output level is fixed. The supply of the good is perfectly price inelastic, assuming firms do not keep stock of the good. The short run is the time period during which at least one of the factor inputs used in the production process is fixed. In the short run, when the price of a good rises, firms can increase the production only by employing more of the variable factor inputs used in the production process. The long run is the time period after which all the factor inputs used in the production process are variable. The supply of a good is more price elastic in the long run than in the short run as firms can increase the production by employing more of all the factor inputs used in the production process.
Mobility of Factors of ProductionThe ease with which factors of production can be moved from the production of one good to another will influence the price elasticity of supply of a good. The supply of a good will be more price elastic the higher the mobility of factors of production. Conversely, the supply of a good will be less price elastic the lower the mobility of factors of production. For example, if a manufacturing firm in the city is able to swiftly employ rural farmers to increase output, the supply of the good is likely to be price elastic.
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6 LIMITATIONS OF THE CONCEPTS OF ELASTICITY OF DEMAND
Irrelevant and Unreliable DataThe data that are used to calculate elasticities of demand may be irrelevant or unreliable. Data from past records may no longer be relevant to calculating elasticities of demand as some of the determinants of demand may have changed. Although data from current market surveys are relevant to calculating elasticities of demand, they may not be reliable as the respondents may not be truthful in their responses. Furthermore, if the sample sizes of the market surveys are small, the results may not be reliable as they may not be reflective of the actual markets for the goods.
Unrealistic AssumptionThe assumption of ceteris paribus that is made in calculating elasticities of demand is unlikely to hold in reality. In reality, many factors such as the level of income, the price of the good and the prices of related goods are changing simultaneously.
Omission of Total CostAlthough PED may be useful for increasing total revenue, this is not true for increasing profit due to the omission of total cost. For example, if demand is price elastic, a fall in price will lead to a larger proportionate increase in quantity demanded resulting in an increase in total revenue. However, if total cost rises by a larger extent, profit will fall.
Omission of Production CapacityPED and XED do not take production capacity into consideration. For example, if demand is price elastic, a fall in price will lead to a larger proportionate increase in quantity demanded resulting in an increase in total revenue. However, total revenue will not rise if there is no excess capacity to increase production.
7 EFFECTSOFELASTICITYONPRICEANDQUANTITY
When demand increases, price and quantity will rise. If supply is price elastic, the increase in price is likely to be small and the increase in quantity is likely to be large.
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In the above diagram, due to the elastic supply which gives rise to the flat supply curve (S0), an increase in the demand (D) from D0 to D1 leads to a large rise in the quantity (Q) from Q0 to Q1 and a small rise in the price (P) from P0 to P1. However, if supply is price inelastic, the increase in price is likely to be large and the increase in quantity is likely to be small.
In the above diagram, due to the inelastic supply which gives rise to the steep supply curve (S0), an increase in the demand (D) from D0 to D1 leads to a large rise in the price (P) from P0 to P1 and a small rise in the quantity (Q) from Q0 to Q1.
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When supply decreases, price will rise and quantity will fall. If demand is price elastic, the increase in price is likely to be small and the decrease in quantity is likely to be large.
In the above diagram, due to the elastic demand which gives rise to the flat demand curve (D0), a decrease in the supply (S) from S0 to S1 leads to a large fall in the quantity (Q) from Q0 to Q1 and a small rise in the price (P) from P0 to P1. However, if demand is price inelastic, the increase in price is likely to be large and the decrease in quantity is likely to be small.
Price
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In the above diagram, due to the inelastic demand which gives rise to the steep demand curve (D0), a decrease in the supply (S) from S0 to S1 leads to a large rise in the price (P) from P0 to P1 and a small fall in the quantity (Q) from Q0 to Q1.
Based on the above analysis, we can see that a large rise in price may be due to four factors. Apart from a large increase in demand and a large decrease in supply, a large rise in price may also be due to an inelastic demand and an inelastic supply. Similarly, a large increase in quantity may be due to four factors. Apart from a large increase in demand and a large increase in supply, a large increase in quantity may also be due to an elastic demand and an elastic supply.
In Chapter 2, we learnt that when demand and supply change simultaneously in the same direction, although quantity will be determinate, the effect on price will depend on the relative changes in demand and supply. For example, when demand and supply rise simultaneously, although quantity will rise, price will fall if the increase in supply is greater than the increase in demand. However, if the increase in demand is greater than the increase in supply, price will rise. Similarly, when demand and supply fall simultaneously, although quantity will fall, price will rise if the decrease in supply is greater than the decrease in demand. However, if the decrease in demand is greater than the decrease in supply, price will fall. One thing we can see here is that when demand and supply change simultaneously in the same direction, a consideration of the relative price elasticities of demand and supply is not necessary. This is because if the increase in demand is greater than the increase in supply, or the decrease in supply is greater than the decrease in demand, a shortage will occur at the initial price which will lead to a rise in price, regardless of the price elasticities of demand and supply. Conversely, if the increase in supply is greater than the increase in demand, or the decrease in demand is greater than the decrease in supply, a surplus will occur at the initial price which will lead to a fall in price, regardless of the price elasticities of demand and supply.
The above analysis is based on the assumption that demand and supply change simultaneously in the same direction. However, if demand and supply change simultaneously in opposite directions, a consideration of the relative price elasticities of demand and supply will be necessary, in addition to a consideration of the relative changes in demand and supply. Suppose that demand rises and supply falls simultaneously. An increase in demand will lead to a rise in price and quantity. A decrease in supply will lead to a rise in price and a fall in quantity. Therefore, price will rise and quantity will be indeterminate. In this case, one may think that if the increase in demand is greater than the decrease in supply, quantity will rise and vice versa. However, this is erroneous. To determine the effect on quantity, one should not only consider the relative changes in demand and supply. This is because the relative price elasticities of demand and supply will also have an effect on quantity and to understand this, we can simply consider the case of Certificate of Entitlement (COE) in Singapore. As the supply of COEs in Singapore is determined entirely by the Land Transport Authority (LTA), it is perfectly inelastic which gives rise to a vertical supply curve. If the demand rises, even if the increase is large, the quantity will not rise. However, if the supply falls, even if the decrease is small, the quantity will fall. Therefore, even if the increase in the demand is greater than the decrease in the supply, the quantity will fall. This example shows that if demand and supply change simultaneously in opposite directions, the directional change in quantity will depend on two factors: the relative price elasticities of demand and supply and the relative changes in demand and supply.
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Suppose that demand increases and supply decreases simultaneously. Further suppose that demand is price elastic and supply is price inelastic. When demand is price elastic, a decrease in supply is likely to lead to a large decrease in quantity. When supply is price inelastic, an increase in demand is likely to lead to a small increase in quantity. Therefore, quantity is likely to fall, assuming the changes in demand and supply are equal.
In the above diagram, an increase in the demand (D) from D0 to D1 and the same decrease in the supply (S) from S0 to S1 lead to a rise in the price (P) from P0 to P1 and a fall in the quantity (Q) from Q0 to Q1. If the decrease in supply is greater than the increase in demand, quantity will almost certainly fall. However, if the increase in demand is greater than the decrease in supply, quantity may rise. In this case, quantity will be indeterminate.
Suppose that demand increases and supply decreases simultaneously. Further suppose that demand is price inelastic and supply is price elastic. When demand is price inelastic, a decrease in supply is likely to lead to a small decrease in quantity. When supply is price elastic, an increase in demand is likely to lead to a large increase in quantity. Therefore, quantity is likely to rise, assuming the changes in demand and supply are equal.
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In the above diagram, an increase in the demand (D) from D0 to D1 and the same decrease in the supply (S) from S0 to S1 lead to a rise in the price (P) from P0 to P1 and a rise in the quantity (Q) from Q0 to Q1. If the increase in demand is greater than the decrease in supply, quantity will almost certainly rise. However, if the decrease in supply is greater than the increase in demand, quantity may fall. In this case, quantity will be indeterminate.
Note: If demand and supply are both price elastic or price inelastic, the effect of a simultaneous increase in demand and a decrease in supply on quantity will depend to a large extent on the relative changes in demand and supply. If the increase in demand is greater than the decrease in supply, quantity is likely to rise. However, if the decrease in supply is greater than the increase in demand, quantity is likely to fall.
