The formulas for income elasticity of demand, cross-price elasticity of demand,

Question

The formulas for income elasticity of demand, cross-price elasticity of demand, and other elasticity concepts are quite similar to that for price elasticity of demand. The only change needed is the substitution of income or price of another good for the price of the good itself in the formula for calculating price elasticity of demand. Interpretation of the elasticity coefficient is a bit different. For income elasticity of demand, if the coefficient Ev is positive the good is referred to as a "normal good," and if E is negative the good to considered an "inferior good.(Inferior" in this usage does not imply poor quality or flawed products, it just means as consumer income increases consumers want to buy less of the good in question.) For cross-price elasticity of demand, if the coefficient Eu is positive the goods are considered "substitutes," and if Eaa is negative the goods are considered "complements." 9. A 10 percent increase in income brings about a 15 percent decrease in the demand for instant soup. What is the income elasticity of demand for instant soup? 10. Given your previous answer, is instant soup a normal good or an inferior good? 11. Calculate the cross-price elasticity of demand for products coffee and tea with the following information: when the price of coffee is $140, the quantity sold of tea is 80 cups; when the price of coffee is raised to $1.80, then 120 cups of tea are sold. 12. Assume the quantity demanded of strawberry jam fell by 2% when the price of peanut butter rose 10%. Calculate the cross-price elasticity of demand between tea and coffee. 13. Given your previous answer, are strawberry jam and peanut butter complements or substitutes? 14. A 10 percent increase in the price of cheeseburgers at a local lunch shop would cause a 5 percent drop in total revenue from cheeseburgers and a 10 percent drop from soft drinks. The company currently sells $1,000 in cheeseburgers and $1,000 in soft drinks each day. Assuming no other effects, would the price increase raise or lower total revenue for the local lunch hop? Explain

Explanation / Answer

Solution:

9) Income elasticity of instant soup, E = % change in demand/ % change in income. As demand is decreasing it will be negative and income is increasing it will be positive.

E= -15/10 = -1.5

10) When the elasticity of demand is negative people tends to move to more luxurious or superior goods as their income increases. As in the above question, the elasticity of demand is negative when income increses. So, the instant soup is inferior good.

11) Given the price of coffe P1= $1.4, The quantity of tea sold Q1= 80

When price of coffe change P2= $1.8, The quantity of tea sold Q2= 120

Cross elasticity of demand for tea, coffee ET, C = % change in demand of tea/ % change in price of coffee

% change can be calculated with the help of actual change divided by actual and final values.

So,

Cross elasticity of demand for tea, coffee ET, C =[ Q2-Q1/((Q2+Q1)/2) ] / [ P2-P1/((P2+P1)/2) ] /

ET, C =[120-80/(120+80)/2)] / [1.8-1.4/(1.8+1.4)/2)]

ET, C = [40/100]/ [0.4/1.6]

ET, C = 0.4/0.25 = 1.6

12) Cross elasticity of demand for strawberry jam and peanut butter, ES, P = % change in demand of Jam/ % change in price of peanut butter.

As demand for strawberry jam is decreasing it will be negative and price of peanut butter is increasing it will be positive.

ET, C =- 2%/10% = -0.2

Note: In question it is saying calculate cross price elasticity of tea and coffee. It must be typo error as data is given for strawberry jam and peanut butter.

13) When the cross elasticity of demand for a product A with relative to change in price of other product B is negative, it means that the quantity of product A is decreasing as the price of product B is increasing. It happens because people consume A and B as a bundle and an increase in price of one good decrease their purchasing power which leads to decrease in consumption of another product. In the previous question the cross elasticity of strawberry jam and peanut butter is negative. So, they are complementary goods.

14) Initial Revenue from cheese burger= 1000 and Initial revenue from soft drinks = 1000

% change in price of cheeseburger = 10%

% drop in revenue from cheeseburger= 5%

% drop in revenue from soft drinks= 10%

Initial total revenue=Revenue from cheeseburger + revenue from soft drinks

1000+ 1000 = $2000

Revenue after change of price of cheeseburger = Revenue from cheeseburger after price change + revenue from soft drinks after price change

= 0.95*1000 + 0.9*1000 = 950+ 900= 1850

Clearly, the revenue after increase in price is decreasing.

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