Question

Q3(using graph(s) and words )Use the economic theories to determine whether the statement in each of the following question is True, False or Uncertain. Please explain using both words and graph(s) and make it concise. Your answer should be around ¾ to 1 page for the question.

Consider a monopoly provider of water tanks. The monopolist could practice third degree
price discrimination by setting a price of $5000 for a 5000-litre water tank to residents in
rural areas, but charge only $4000 for the same 5000-litre water tank to urban residents
because the elasticity of demand is more inelastic in urban areas.

Answer 1

A monopoly provider of water tanks and it charges different prices to the people of different areas. In rural areas it charges higher price ($5000) compare to urban areas ($4000) for 5000 litre water tank. The logic has been said that the elasticity of demand is more inelastic in urban areas. ---- This is false.

Because we know that elasticity of demand and price charge on that market is inversely related. We know the monopoly power or we can say mark-up over its marginal cost relation with elasticity is (P - MC)/P = 1/Ep, or P - MC = P/Ep , or , P = MC + P/Ep , or P - P/Ep = MC , or, P(1-1/Ep) = MC, or, P ={ MC(1-1/Ep)}. Now in this relation we assume two type of elasticity one is inelastic and other is elastic. Let suppose in comparatively inelastic demand elasticity is Ep = 2, in case of comparatively elastic demand elasticity is 4. It means we assume in urban areas due to comparatively inelastic demand elasticity is 2, in rural areas due elastic demand elasticity is 2.666. For simplicity we assume MC =2500 in both cases.

In this condition when Ep =2, MC =2500, P = MC/(1-1/Ep) = 2500/1-1/2 = 2500/1-0.5 = 2500/0.5 =5000

Now if Ep =2.666, MC =2500, P = MC/(1-1/Ep) = 2500/1-1/2.666 = 2500/1-0.375 = 2500/0.625 = 4000

It means where elasticity is lower (Ep =2) price is higher 5000 and where elasticity is higher (Ep =2.666) price is lower i.e 4000. In case of comparatively inelastic demand (lower elasticity) price will be higher and in case of elastic demand (higher elasticity) price will be lower.

So the statement of comparative inelastic demand (urban areas) implies lower price is false argument in case of urban areas.

To explain it more clearly we consider following figure -