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Analysis 1: Calculating and Interpreting Elasticity


Part I, a): Price elasticity of Demand

Price elasticity of demand = (change in quantity/average of old and new quantities) ÷ (change in price/average of old and new prices)

= [(500-400)/ (500+400)/2] ÷ [(1-1.5)/ (1+1.5)/2)]

= (100/450) ÷ (-0.5/1.25) = (0.22 ÷ -0.4) =-0.8

b).

The demand for oranges is inelastic. If the calculated value of elasticity is 0, then the demand is perfectly inelastic, greater than one means elastic, less than one means inelastic, while infinite value of elasticity means perfectly elastic demand.

c).

Total revenue = Price × Quantity Sold

Revenue before price change= 500 × $1= $500

Revenue after price change= 400 × $1.50= $ 600

The total amount of revenue is higher after than before price. This is consistent with the conclusion from the calculation that the demand for oranges is inelastic. This means that consumers will continue to buy oranges at the same level of demand despite price increase.


 Part II, a). Income elasticity of demand

Income elasticity of demand = percentage change in quantity demanded / percentage change in income

= [(2-10)/ (10) ÷ (30,000-20,000)/ (20,000)]

= {(-8/10) ×100] ÷ [(10,000/20,000) ×100]} = -80% ÷ 50% = -1.6

b). The calculated value of income elasticity of demand is negative meaning that the demand for spaghetti went down after an increase in income. For a normal good, demand increases with an increase in income, while for an inferior good, demand decreases with an increase in income. This means that spaghetti is an inferior good.


Part III, a). Cross-price elasticity of demand

Cross-price elasticity of demand=percentage change in quantity demanded/ percentage change in price of alternative good

=15%/30%= 0.5

b). Pepsi and Coca-Cola are substitutes. The calculated value of cross-price elasticity of demand is positive meaning an increase in the price of Coca-Cola will shifts demand to Pepsi, depending on the difference in percentage change.


Reference

Taylor, J. (2007). “Principles of Economics”. Boston, MA: Houghton Mifflin Company


 
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