Question

In the short run, the price elasticity of the demand and supply of electricity can be very low.

Answer 1

Answer:

A. Revenue for the industry would increase

B. Short term incentive to shut down a power plant

Explanation:

The price elasticity of demand is a concept that determines the variability of the demand of a product or service relative to changes in its price. We know that the demand curve is a downward sloping curve so any changes in price will result in a lower level of demand. Exactly how much the demand will reduce in percentage terms relative to a percentage increase in price is calculated using the price elasticity of demand. If a demand is inelastic (i.e the price elasticity is low) for any percentage increase in price will lead a less than proportionate increase in demand. So for example, a 10% increase in price will lead to a less than 10% decrease in demand.

In our question, the first part indicates that a power plant has been shut down which decreases the supply. This is indicated by an inward shift of the supply curve to the left. This inward shift would cause the price to increase. However, since the price elasticity of demand is very low in the short run, the demand will increase by a LOWER percentage. Therefore overall revenues of the industry would increase. To show this as an example, lets assume that the price was $1 for which demand was 100 units. Existing revenue is therefore $100. Due to the shift in supply, prices increase upward by 10%. The new price would be $1.1. However since the demand is inelastic, the demand would reduce by less than 10% (lets assume by 5%). The new demand would then be 95 units. The new revenue would be $104.5. Therefore, we can see that industry revenue would increase.

The answer to option B is similar to above. The caveat is that since one company has many power plants, it controls a significant portion of total industry supply, making it a monopoly. In this scenario, its fair to assume that if the company reduces its supply, there is a negligible risk of a competitor firm increasing its supply to capture the market. So the company would have a short term incentive to shut down a plant every now and then to capitalize on the the higher revenue generated from the associated increase in price. Furthermore, shutting down a plant would save up on costs which would allow profits to increase even more in the short run