Question

2) Economists at the Coca Cola company have estimated that the cross price elasticity of demand between Coke and Pepsi is 0.90. They have also estimated that the income elasticity of demand for Coke is 1.5.

a. Pepsi has recently lowered the price of Pepsi-Cola by 10%. What impact will this have on the demand for Coke? What advice would you give to Coke in terms of how it responds to this move by Pepsi?

b. Economists estimate that real GDP (national income) will increase by 3% this year. What impact will this have on the demand for Coke?

Answer 1

a.

Cross price elasticity of demand is the responsiveness of change in quantity demand of one good due to a change in the price of another good. Considering here the two goods are Pepsi and Coke, the cross-price elasticity of demand can be given by the following formula:

Cross price elasticity of demand between Coke and Pepsi = % change in the quantity of Coke / % change in the price of Pepsi

Putting in the values in the above formula we get:

0.90 = % change in quantity demanded of Coke / (-10%)

% change in quantity demanded of Coke = 9%

Thus, a 10% price decrease by Pepsi leads to an increase in the quantity demanded of Coke by 9%. In response to the increase in demand for Coke by 9%, the firm producing Coke should increase the supply of Coke in order to fulfill the increased demand.

b.

Income elasticity of demand is the responsiveness of change in quantity demanded due to a change in income. It is given by the following formula:

Income elasticity of demand = % change in the quantity demanded of Coke / % change in national income

1.5 = % change in the quantity demanded of Coke / 3%

% change in the quantity demanded of Coke = 4.5%

This means that a 3% increase in national income will lead to a 4.5% increase in the demand for Coke.