Question

b) Is it advisable for a coffee shop owner to increase the price of his coffee if demand for coffee is price inelastic? Explain briefly using a diagram that demonstrates the impact on the firm’s Total Revenue.

c) Nicolas says that if income elasticity of demand for sugar is -0.7, sugar is an inferior good. Steve disagrees and claims that it is a necessity. Define income elasticity of demand and explain who is right and who is wrong with their statements above?

d) For Australian consumers of petrol, would the price elasticity of demand be greater for Shell petrol or petrol in general? Explain your reasoning

Answer 1

Part b)

Yes it is advisable for a coffee shop owner to increase the price of his coffee if demand for coffee is price inelastic which means that there are very few close substitutes for his coffee. Any shop is concerned with total revenue and if the price elasticity of demand is inelastic, the total revenue increases as we increase the price. That is, price increases and quantity decreases, but total revenue = price * quantity increases.

Part c)

Income elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in income.

Income elasticity of demand = (dQ/Q)/(dM/M) = (M/Q)*(dQ/dM)

If income elasticity of demand is negative (as is in -0.7) it is deemed as an inferior good as we consume it less and less as income rises. Necessary goods have income elasticity of demand between 0 and 1. Hence Nicolas is right and Steve is wrong.

Part d)

The difference between Shell petrol and petrol in general is that Shell petrol has only one manufacturer(Shell obviously) while petrol in general is produced by many oil companies around the world. Hence we can say that there are many substitutes to Shell petrol (that is petrol produced by other companies) but there are very few substitutes to petrol in general (Substitutes include diesel, gasoline etc, but these aren't perfect substitutes, each has its own different purpose).  

Hence we can say that price elasticity of demand is lesser( more inelastic ) for petrol in general as compared to Shell petrol(relatively elastic)