Question

Rice and beans	(–0.25)
Rice and wheat	0.50
Rice and chicken	(–0.15)
Rice and milk	(–0.05)
Rice and other goods	0

You are a planner for the country represented above. The income elasticity of demand for rice is 0.8.:

Is this likely a relatively wealthy or relatively poor country? Why?

Use the information above and the homogeneity condition to determine the necessary percentage change in the price of rice that will raise the consumption of rice by 5%.

If rice consumption increases by 5%, what precisely are the implications for the demands for substitute goods?

What are general implications of what is known as the ‘income’ effect and the ‘substitution’ effect on your response to this question?

Answer 1

Income elasticity of rice is negative. This means that when income increases demand for rice increases by lower proportion. Rice is a necessity. The country is relatively rich because small proportion of income is spent on necessary goods.

Homogeniety condition-

Own elasticity + income elasticity + sum of cross price elasticity = 0

Own Price elasticity + 0.8 + ( -.25+.5-.15-.05)= 0

Own Price elasticity= -0.85

Now own Price elasticity=

%change in quantity/%change in price

-0.85= 5/%change in price

%change in price = - 5.88

If rice consumption increases by 5% demand for substitution might have fallen as only good is consumed if it has substitutes.

Income effect can be derived from income elasticity which tells the change in consumption of good due to change in price

Substitution effect can be derived from cross price elasticity which tells change in consumption of the good due to change in price of other goods.