Question

a. The price elasticity of a good is -4.2. What does this mean? What would happen to the total revenue collected if prices were to increase by 10% and explain your answer.

b. The income elasticity of a good is 0.25. What does this mean? What can we conclude about this good and explain how you came to this conclusion?

c. The cross-price elasticity of a good is -1.5. What does this mean? What can we conclude about this good and explain how you came to this conclusion?

Answer 1

a. The price elasticity of demand is the responsiveness of change in quantity demanded due to a change in prices of the goods. This means that if the demand is more responsive to the change in prices, then the demand is more elastic. If the demand is less responsive to the change in prices, the demand is less elastic. It is given by the following formula:

Price elasticity of demand = % change in quantity demanded / % change in price

If the value of price elasticity of demand is more than 1 then it would be called elastic demand.

If the value of price elasticity of demand is less than 1 then it would be called inelastic demand.

If the value of price elasticity of demand is equal to 1 then it would be called unitary elastic demand.

Here the value of the price elasticity of demand is 4.2 which is more than 1, thus the demand will be elastic.

(Note: Here minus sign just represents the negative relationship between quantity demanded and price of the good)

When the price elasticity of demand is elastic then price and total revenue have a negative relationship. Thus, if the prices increase by 10%, the total revenue would decrease.

This happens because when the demand is elastic, the responsiveness to change in prices is more. So, when prices increase, the quantity demanded will fall to a great extent, which will cause total revenue to fall.

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

Income elasticity of demand = % change in quantity demanded/ % change in income of the consumer.

Inferior goods are the ones that have an indirect relationship with the income of the consumers. Suppose an employee who takes a bus to go to work gets a promotion and then he switches from bus to cab. The bus here will be considered as the inferior good since its demand decreased with the increase in income of the consumer.

Normal goods are the ones that have a direct relationship with the income of the consumers. Goods like food items, furniture, clothes, etc. The demand for these goods increases as the income of the consumers increases. Normal goods are of two types, necessity, and luxury goods.

Income elasticity of necessity goods is less than 1 (it is less than 1 because the demand for these goods is not much affected by the income of the consumer). Even if the income decreases a bit, consumers will consume the necessary goods like bread, eggs, etc.

Income elasticity of luxury goods is more than 1 (this is because the change in income largely affects the purchase of luxury goods)

Here, the income elasticity is 0.25, which is positive and less than 1, thus it will be a necessity good.

c. Cross price elasticity of demand is the responsiveness of change in quantity demanded of one good by the change in the price of another good. It is given by the following formula:

Cross price elasticity of demand for good A = % change in quantity demanded of good A/ % change in the price of good B

If the value of the cross-price elasticity of demand is positive then the goods will be substitutes. Substitutes are the goods that are used in place of one another like tea and coffee.

If the price elasticity of demand is negative then the goods are complements. Complement goods are the ones that are bought together like car and petrol, refill and pen etc.

Here, we can see that the cross-price elasticity is negative thus, the goods are complements.