Homework sheet 3

Q1. The Acme Paper Company lowers its price of envelopes (1000 count) from Rs. 6 to Rs. 5.40. If its
sales increase by 20 percent following the price decrease, what is the elasticity coefficient?

Solutions: % change in Price 5.40-6/6 × 100= 10%

% change Q 20%
————— = — = -2
% change P 10%

Q2. The demand function for a cola type soft drink in general is Q= 20-2P where Q stands for
quantity and P stands for Price

a. Calculate point elasticities at price of 5 and 9. Is the demand curve elastic or inelastic at
these points?

Ans: Q = 20 - 2P; slope ∆Q/∆P = -2

When P = 5 , Q = 10 Q= 20 - 2×5= 10

So Elasticity ε p = -2 x 5/10 = -1 Unitary elastic

P= 9 , Q= 20-2×9 = 2

ε p = -2 x 9/2 = -9 Elastic

b. Calculate arc elasticity at interval between P=5 and P= 6

Ans: At P = 5, Q = 10
At P = 6, Q = 8
−2× 5.5
= 11/ 9= 1.22
1× 9

c. At what price would a change in price and quantity result in approximately no change in
total revenue? Why?

ANS: Price Quantity P* Q= Total Revenue

4 12 48
5 10 50
6 8 48
7 6 42

At a price of $5, revenue reaches its peak. This is also where point price elasticity is 1, as
shown in part a. of this problem.

Q3 The equation for demand curve has been estimated to be Q= 100-10P +.5Y where Q is Quantity,
P is price and Y is income. Assume P= 7 and Y= 50
 a. Interpret the Equation

Ans: When price changes by 1, quantity will change by 10 in the opposite direction.

When income changes by 1, quantity will change by 0.5 in the same direction. The Good is normal
good.

b. At Price of 7, what is Price Elasticity

Slope = - 10

ε p = (- 10) x (7/55) = -1.27

c. At an income level of 50, what is income elasticity

Ans: Point elasticity
Slope = 0.5

ε y = (.5) x (50/55) = 0.45

d. Now assume income is 70. What is price elasticity at P= 8

Ans: Point elasticity

Q = 100 - (10)(8) + (.5)(70) = 55

ε p = (-10) x (8/55) = -1.45

Q4. The teenager Company makes and sells skateboards at an average price of $ 70 each. During
past year, they sold 4,000 of these skateboards. The company believes that the Price elasticity for
this product is about -2.5. If it decreases the price to $ 63 , what should be quantity sold? Will
revenue increase? Why?

Ans: (x - 4000) (63 - 70)

-2.5 = ———— / ————
(x + 4000) (63 + 70)

x = 5212

At P = 70, TR = 4000 x 70 = 280,000

P = 63, TR = 5212 x 63 = 328,356

Revenue will increase, because demand curve is elastic.

Q5 According to a study, the price elasticity of shoes in United States is 0.7 and the income elasticity
is 0.9

a. Would you suggest that the Brown shoe Company cut its prices to increase its revenue?

Ans: The price elasticity for shoes in the U.S. is 0.7. However, the elasticity for Brown
Shoe Company's shoes may be higher, since a particular make of shoes has more substitutes than
 shoes in general. The exact demand elasticity for Brown's product is not known, but it could
easily be greater than 1 (or less than negative one), and thus a price decrease could lead to an
increase in revenue.

b. What would be expected to happen to the total quantity of shoes sold in United States if
income rise by 10 percent?

Ans: The quantity of shoes sold in the U.S. would rise by 9%.

Q6 Would you expect the Cross elasticity coefficients between each of the following pairs of
products to be positive or negative ? Why?

a. Personal computers and software

b. Electricity and natural Gas
c. Apples and Oranges
d. Bread and VCRs

Ans:

a. Negative – they are complements..

b. Positive—they are substitutes.
c. Positive—they are substitutes.
d. They appear to be unrelated products (thus, cross-elasticity of demand is not significantly
different than zero). While there is no relationship between these two products, both of
these may compete for same budget . From a total budget viewpoint, they could be
considered to be substitutes. But usually, the relationship between the two would be very
weak.

Q7. Discuss relative Price Elasticity of the following Products:

a. A specific brand of mayonnaise - Probably fairly elastic, since there are many good
substitutes for a specific brand of mayonnaise.

b. Jaguar Cars- As a “luxury,” the Income elasticity for a Jaguar could be considered to be
relatively elastic. But since such automobiles are purchased by people in a high income
category, the Price elasticity could also be quite high.

But The answer probably depends on whether other high-priced cars (Mercedes, BMW,
Infinity, etc.) are considered to be close substitutes or not .If yes then Price elasticity will be
high.
c. Washing Machines- Probably rather elastic. It represents a significant expenditure. Further, a
repair may significantly prolong its life.
d. Air Travel (Vacation)- Probably rather elastic since other vacation arrangements (driving,
bus, train) could be substituted. Also, it represents a significant portion of total vacation
cost.

e. Diamond Ring- Probably quite elastic since they represent a large expenditure. If given as a
gift, there are probably many other items which can be good substitutes.
Q8Which product will exhibit a higher elasticity with respect to interest rates, automobiles or
smaller appliances? Why

Ans: Most likely automobiles, since they represent a larger expenditure and are more likely to be
purchased by borrowing on a longer term basis.

Q9 a) In India, would you expect the price elasticity of demand to be higher for Maruti SX4
automobiles or for automobile in general? Why?

Ans: We would expect the price elasticity of demand for Maruti SX4 to be much higher than
the price elasticity of demand for automobiles in general because there are many good
substitutes for SX4 , while few good substitutes are available for automobiles in
general.
b) Would you expect the price elasticity of demand for electricity for residential use in India to be
higher or lower than that for industrial use? Why?

We would expect the price elasticity of demand for electricity for residential use to be
much greater than for industrial use because industrial users, using large amounts of
electricity, could generate their own electricity. This is generally not feasible for
residential users of electricity.
c) Would you expect the Price elasticity od demand for electricity to be higher or lower in short run
as compared with the long run? Why?

We would expect the price elasticity of demand for electricity to be larger in the long
run than in the short run because in the long run there is more time to learn about the
availability of substitutes (such as gas ovens, solar energy, etc.) and to switch over to
substitutes
d)Why price elasticity of electricity for residential and industrial use is different in India and United
States? Give appropriate reasons

Q10. Agriculture commodities are known to have a price inelastic demand and are considered to be
necessities. Use this information to explain why the income of farmer’s fall

a) After a good harvest - A good harvest increases the supply of agricultural commodities.
Given the demand for agricultural commodities, this results in lower prices for farm
products. Since the demand for agricultural commodities is price inelastic, the
reduction in prices after a good harvest leads to a decline in the total revenues
(income) of farmers. In relation to the incomes from other sectors of the economy
(b) Since agricultural commodities are necessities (i.e., their income elasticity of demand
 is positive but has a value below one), the increase in consumers’ income in the
process of economic growth leads to a smaller than proportional increase in the
demand for agricultural commodities. As a result, farmers’ incomes rise less than
proportionately in comparison to the rise in income in other sectors of the economy.
Q11 Suppose the cross price elasticity of demand between Red Delicious (Himachal Pradesh) apples
and Golden Delicious (J&K) apples is 0.9, between apples and apple juice is 0.7 , between apples and
cheese is -0.4 and between apples and beer is - 0.3. What can you deduce about the relationship
between each set of commodities?

Since the cross-price elasticity of demand between Red Delicious and Golden-Delicious
apples is positive and very large (0.9) they are very close substitutes. Since the cross-price
elasticity of demand between apples and apple juice is positive (0.7), apples and apple juice
are substitutes but are good substitutes.
Since the cross-price elasticity of demand between apples and cheese is negative and not
very large (-0.4), apples and cheese are complements, but not very good complements.
Finally, since the cross-price elasticity of demand between apples and beer is close to zero,
apples and beer are practically independent commodities.