Question

Taiwan is a major world supplier of semiconductor chips. A recent earthquake severely damaged the production facilities of Taiwanese chip-producing companies, sharply reducing the amount of chips they could produce. a. Assume that the total revenue of a typical nonTaiwanese chip manufacturer rises due to these events. In terms of an elasticity, what must be true for this to happen? Illustrate the change in total revenue with a diagram, indicating the price effect and the quantity effect of the Taiwan earthquake on this company's total revenue. b. Now assume that the total revenue of a typical nonTaiwanese chip manufacturer falls due to these events. In terms of an elasticity, what must be true for this to happen? Illustrate the change in total revenue with a diagram, indicating the price effect and the quantity effect of the Taiwan earthquake on this company's total revenue.

Short answer

For the non-Taiwanese manufacturer's total revenue to rise, the demand for chips must be inelastic; an increase in price leads to a relatively small decrease in quantity demanded, increasing total revenue. Conversely, for total revenue to fall, the demand must be elastic; an increase in price leads to a relatively large decrease in quantity demanded, decreasing total revenue.

Step-by-step solution

Understanding the Price Elasticity of Demand

To determine what must be true for the non-Taiwanese chip manufacturer's total revenue to rise or fall after the reduction in chip supply from Taiwan, we need to consider the price elasticity of demand. The price elasticity of demand measures the responsiveness of quantity demanded to a change in price. If the demand for chips is inelastic, a higher price will lead to an increase in total revenue. Conversely, if the demand is elastic, a higher price may lead to a decrease in total revenue because the quantity demanded will decrease more than the increase in price.

Illustrating the Impact on Total Revenue for Increased Revenue Scenario

For total revenue to rise, the demand must be inelastic. This means that when price increases, the quantity demanded decreases by a proportionally smaller amount, leading to an increase in total revenue. On a diagram, the demand curve would be relatively steep, and the area representing total revenue (price multiplied by quantity) after the earthquake would be larger than before. The `price effect` (increase in price) outweighs the `quantity effect` (decrease in quantity sold), resulting in increased total revenue for the non-Taiwanese manufacturer.

Illustrating the Impact on Total Revenue for Decreased Revenue Scenario

For total revenue to fall, the demand must be elastic. This means that when price increases, the quantity demanded decreases by a proportionally larger amount, leading to a decrease in total revenue. On a diagram, the demand curve would be relatively flat, and the area representing total revenue after the earthquake would be smaller than before. The `quantity effect` (significant decrease in quantity sold) outweighs the `price effect` (increase in price), resulting in decreased total revenue for the non-Taiwanese manufacturer.

Key concepts

Total Revenue

Understanding the essential concept of total revenue is the starting block for any analysis related to price elasticity of demand. Total revenue, in simple terms, is the amount of money a company earns from the sale of its goods or services. To calculate it, you multiply the price per unit of a good by the number of units sold.

In the context of the semiconductor industry, if a non-Taiwanese chip manufacturer observes an increase in total revenue following a disaster in Taiwan, it indicates that despite potential changes in price, the quantity sold multiplied by the price has resulted in a higher income. This interplay between the price of the chips and the quantity sold is crucial in understanding the dynamics of a market, particularly when external factors, like natural disasters, disrupt supply chains.

Inelastic Demand

When we talk about inelastic demand, we're referring to a situation where the quantity demanded of a product doesn't significantly change as the price changes. This could be the case for products seen as necessities or those with few substitutes, like certain medications or, in our case study, semiconductor chips.

If the total revenue of the non-Taiwanese chip manufacturer increases post-earthquake, it suggests that the demand for their chips is inelastic. Consumers or companies needing these chips will still purchase them even at higher prices, because they may not have other sources to turn to, or the chips are essential for their products. This robust demand implies limited sensitivity to price changes.

Elastic Demand

In contrast to inelastic demand, elastic demand is characterized by a significant change in quantity demanded when there's a slight change in price. Products with elastic demand typically have several alternatives available in the market, and consumers can switch to these substitutes if prices rise.

If we observe a decrease in total revenue for the chip manufacturer after an event like the Taiwan earthquake, it signals that the demand for their product is elastic. When the manufacturer raises the prices due to the reduced supply, the quantity of chips sold drops substantially, as customers turn to other manufacturers or find alternatives, leading to a decline in total revenue.

Quantity Effect

The quantity effect is one part of the equation when analyzing changes in total revenue. It is the impact on revenue due to the change in the number of units sold. When prices rise, typically, fewer units are sold, which would generally tend to decrease total revenue—unless the price increase is sufficiently substantial to offset the reduced quantity.

In the scenario where the manufacturer's total revenue goes up, the quantity effect is less pronounced than the price effect. This suggests that while fewer chips are sold due to the increase in price, the increment in price per chip is high enough to boost total revenue.

Price Effect

The price effect also plays a pivotal role in understanding total revenue fluctuations. It refers to the change in revenue brought about by variations in the price of a product. When prices increase, each unit sold brings in more revenue, which could lead to higher total revenue if the demand is inelastic.

In the example of a declining total revenue following the earthquake, the price effect was not strong enough to compensate for the loss of revenue due to the quantity effect. The manufacturer raised prices, but the quantity demanded dropped so substantially that the additional revenue per chip didn't make up for the reduced sales volume, leading to a net decrease in total revenue.