In City X, the Eastern Tunnel increased the tolls by an average of 67% on 1 January 2021. According to the estimates of government, the higher tolls will eventually reduce the eastern tunnel’s traffic flow by 17% and raise the traffic flows of the Western Tunnel and the Central Tunnel by 21% and 3% respectively.

(a) Based on the government’s estimates, calculate the price elasticity of demand for the service of the Eastern Tunnel and compare the closeness of substitution between the Eastern Tunnel and the other two tunnels.

(b) ABC Company is a major stakeholder of both the Eastern Tunnel and the Western Tunnel. Therefore, the profit of this company will rise and fall with the joint profit of the two tunnels, other things being equal. Assume that the costs of operating the two tunnels will remain unchanged despite the changes in the traffic flows of each of them.

Based on your answer in (a), explain with appropriate diagrams whether ABC Company will gain or lose from the increase in tolls. [Hints: (i) Assume each tunnel only charges a fixed amount of toll on all vehicles. (ii) A company’s gain or loss depends on the profits but not just revenues.]

Answer rating: 100% (QA)

a To calculate the price elasticity of demand for the Eastern Tunnel we need to use the formula Price elasticity of demand change in quantity demanded ... View the full answer