4. When the price of home heating oil increases by 20%, the quantity demanded of home...

4. When the price of home heating oil increases by 20%, the quantity demanded of home heating oil decreases by 2% and the demand for wool sweaters increases by 10%.

I) Calculate the elasticity of demand for home heating oil.

II) Is the demand for home heating oil elastic or inelastic? Why?

III) If the price of a wool sweater did not change, calculate the cross elasticity of demand for wool sweaters with respect to the price of home heating oil.

[Hint: Good X is wool sweaters, and Good Y is home heating oil.]

IV) Are home heating oil and wool sweaters substitutes or complements? Why?

Solutions

Expert Solution

Answer to the question no. 1 and 2:

Using the following formula we can find the price elasticity of demand:

Price elasctity of demand of home heating oil (Good Y)= - (Percentage change in the quantity demanded) / (Percentage change in the price) = - (2%) / (20%)= - 0.1

The Price elaticity of demand for home heating oil is 0.1, which is less than 1. This signifies that the demand for home heating oil is inelastic.

Answer to the question no. 3 and 4:

Using the following formula we can find the cross elasticity of demand:

Cross elasctity of demand between X and Y= (Percentage change in the quantity demanded of X) / (Percentage change in the price of Y) = (10%) / (20%) = 0.5

The cross elasticity of demand between home heating oil and wool sweaters is 0.5. This implies that the wool sweater is a substitute to the home heating oil. Because, with a increase in the price of the home heating oil, the demand for the woolen sweater increases. Given the value of cross elasticity less than 1, we can infer that the goods are not perfect subtitutes, but they are substitutes.

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