Question 4.1 When the price of cars is $15,000 each, 10,000 cars are sold every month. After increasing the price to $16,500 each, 9,380 cars are sold every month. At the original price, what is the price elasticity of demand for cars?
Solution 4.1
The correct answer is (D)
Change in quantity of car demanded = 620
Average quantity of car demanded is (10000 + 9380)/2 = 9690
Change in price of car = $1500
Average price of car is ($15000 + $16500)/2 = 15750
The price elasticity of demand is (620/9690)/(1500/15750)= 0.67
Question 4.2 To increase total revenues, firms with ______ demand should lower price and firms with ______ demand should increase price.
A) elastic; elastic
B) inelastic; inelastic
C) elastic; inelastic
D) elastic; unit elastic
E) inelastic; elastic
Solution 4.2 The correct answer is (C)
• If demand is elastic, consumers are sensitive to price change. So firms should reduce price to sell a lot more and hence earns higher revenue.
• If demand is inelastic, consumers are not sensitive to price. A higher price will only reduce quantity demanded by a small amount and hence total revenue increases.
Question 4.3 The price elasticity of demand for apartments is 2.8 while the price elasticity of demand for soft drinks is 0.3. The likely reason for the difference is because
A) There are few substitutes for soft drinks
B) It is easy to produce soft drinks but difficult to build apartments
C) The fraction of income spent on soft drinks is very small
D) Soft drinks are a necessity
E) Apartments are a luxury
Solution 4.3 The correct answer is (C).
• The price of apartment is very high compared to that of soft drinks, relative to consumers’ income.
• If price of both products increase by 10%, it is a small amount of money for soft drinks but a large amount of money for apartment.
• Hence consumers are more sensitive to the changes in the price of apartment and less sensitive on soft drinks.
4.4 Question
(a) An instant noodle manufacturer observes that when the mean income of his consumers is $2000 per month, he can sell 5000 packets of instant noodle per day. But with economic growth and average income of his consumers increase to $2500, he can sell 4500 packets of instant noodle. Calculate the income elasticity of demand of the instant noodle. What will happen to his revenue when the economy enters a recession?
(b) A seller of a product Z discovered that when the price of another product W is $5 per unit, he can sell 750 units of Z. When the price of W increases to $6.50, he can sell 580 units of Z. Calculate the cross elasticity of demand between Z and W. What will happen to his revenue when price of W decreases?
4.4 Solution
a) The income elasticity of demand is (-500/4750) /(500/2250) = -0.474. Since the income elasticity of demand is negative, instant noodle is an inferior good and the seller will be able to earn higher revenue when the economy enters a recession.
(b) The cross elasticity of demand between Z and W is (-170/665)/(1.5/5.75) = -0.98.
Since the cross elasticity of demand between Z and W is negative, Z and W are complements. When the price of W decreases, the revenue from selling Z will increase.
4.5 Question: Given that a product X has income elasticity of demand equals -2.5, its cross elasticity with another product W is -1.8, and its price elasticity of supply is 2.6, what can you comment about the nature of this product?
• Solution to 4.5 The product X is an inferior good since the income elasticity of demand is negative
• The product X is a complement to the product W since the cross elasticity of demand is negative
• The product X is price elastic in supply since the price elasticity of supply is greater than 1
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