Question

4. Consider two markets, A and B, that have different price elasticities of demand and supply. Market A has price elastic demand and supply functions. Market B has very price inelastic demand and supply functions. a. Graph demand and supply curves for these two markets and describe how the curves differ across the 2 markets. b. Suppose both markets are subject to shocks that shift demand or supply from week to week. Further suppose that the shocks are similar (in % terms) for the 2 markets. Which market will have more volatile (i.e., variable) prices? Explain your answer. HINT: Think of a demand shock as a horizontal shift in the demand curve - e.g., a shift equal to 1% of the initial equilibrium quantity; similarly for a supply shock.

Answer 1

a) The graph is shown below

Inelastic demand indicates that the demand will not change drastically even if there is a considerable rise in the price of the product. A perfectly inelastic demand will not change at all for the price rise. The demand curve for inelastic demand will steeper and will be similar to a vertical line.

Price Price Inelastic Demand Elastic Demand Quantity Quantity

Elastic demand is the which is sensitive to the price and the demand will change with the price rise. The shape of the curve will be flatter which indicates that the change in the curve will material for a change in the price.

b) The market with elastic demand curve will witness price volatility because the effect on the revenue will be higher in that market. The curve is flatter so a small change in the price will have a high effect on the quantity demanded. This will affect revenue. However, the steeper demand curve will see a little change in the quantity demanded even if the change in price is higher.

Price Price Inelastic Demand Elastic Demand Q1 Quantity 0201 Quantity