A specific McDonald’s franchise owner is looking at elasticities of Big Macs. E(

Question

A specific McDonald’s franchise owner is looking at elasticities of Big Macs. E(p)= 2 (Price), E(i)=1 (Income), E(mt)=1.5 (m=Big Mac, t= Taco). The franchise owner would like to increase the price of Big Macs by 6%. The owner read an economic report saying incomes will grow by 4% next year and due to a strong marketing campaign by Taco Bell, the price of Tacos will fall by 2%.

If the franchise owner currently sells 1,200 Big Macs a day, how many Big Macs a day can the owner expect to sell?

If the ow ner wants to keep units sold the same at 1,200 per day, by what percentage must the owner change the price of Big Macs?

Explanation / Answer

Current quantity = 1200

E(p) = 2, so 2% increase in price will decrease Q by 4%, causing a decrease in quantity of 48.

E(i) = 1, so 4% increase in income will increase Q by 4%, causing an increase in quantity of 48.

E(mt) = 1.5, so a 2% decrease in taco price will decrease Big Mac quantity by 3%, causing a decrease in quantity of 36.

Net effect on demand = 48 (decrease) + 48 (increase) + 36 (decrease) = decrease of 36 units

New quantity = 1200 - 36 = 1164 (3% decrease)

E(p) = 2

Now, owner wants to increase the quantity to 1200 (from 1164). This means an increase in quantity of 3.093%.

Since E(p) = 2, a 3.093% increase in quantity must be supported by a (2 x 3.093%) = 6.186% decrease in price.

Note: It's assumed that absolute value of E(p) is 2, that is, E(p) is negative following law of demand.

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