Suppose the demand for Brand A Ice Cream is characterized by the following point

Question

Suppose the demand for Brand A Ice Cream is characterized by the following point elasticities: own price elasticity = -0.8 cross-price elasticity with Brand B Ice Cream = +2 income elasticity = +3 Based on the given elasticities, answer the following. Explain your answers. a. If a firm in the industry wishes to increase total sales revenue (ignoring cost considerations), will it raise or lower its selling price? Why? b. What happens to the demand for Brand A Ice Cream if the price of Brand B Ice Cream rises by 10%? Explain your answer. c. What happens to the demand for Brand A Ice Cream if consumer income falls by 4%? Be specific. d. Is Brand A Ice Cream a normal or inferior good? Explain.

Explanation / Answer

(a)

Own price elasticity of demand = - 0.8

Since absolute value of own price elasticity is less than 1, demand is inelastic. With inelastic demand, an increase in price will increase total revenue.

Therefore, the firm should consider increasing its selling price.

(b)

Cross price elasticity of demand between A & B = +2

So, if price of B increases by 1%, quantity demanded of A increases by 2%.

If price of B increases by 10%, quantity demanded of A increases by (2 x 10%) = 20%.

(c)

Income elasticity = +3

So, as income decreases by 1%, quantity demanded decreases by 3%.

If income decreases by 4%, quantity demanded will decrease by (3 x 4%) = 12%.

(d)

Since income elasticity is positive, with increase in income, demand for the product increases. Therefore it is a normal good.

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