Question

When the Shaffers had a monthly income of $8,000, they would usually eat out eight times a month. Now that the couple makes $8,500 a month, they eat out 10 times a month.

            a.         Compute the couple’s income elasticity of demand. Explain your answer. (Is a restaurant meal a normal or an inferior good to the couple?)                                                                                                      

            b.         List and explain the determinants of the price elasticity of demand.

Answer 1

a) The income elasticity of demand is a measure that is used to find the responsiveness of consumption or quantity demanded of a good when consumer's income changes by a given percentage. It is computed as the ratio of %change in Qd to %change in income. Here dining frequency is increased by 2 which means %change in Qd = 2*100/8 = 25% and %change in income = 500*100/8000 = 6.25%. Hence, income elasticity of demand = 25%/6.25% = +4. Since income elasticity of demand is positive, a restaurant meal is a normal good.

b) Determinants of PED include

• Number of substitutes: For more and close substitutes, the demand is relatively elastic
• Degree of necessity: If the goods are necessities, they have inelastic demand, for luxuries, demand is elastic
• Time period: short run has demand for most goods inelastic as preferences cannot be changed in the short run. Long run has elastic demand.
• Proportion of income spent: For goods on which a greater proportion of income or budget is spent, the demand is elastic. If proportion in the budget is small demand is inelastic.