Question 5: A. The initial price of a cup of coffee is $1, and at that price, 400 cups are demanded.

If the price falls to $0.90, the quantity demanded will increase to 500. a) Calculate the (arc) price elasticity of demand for coffee. b) Based on your answer, is the demand for coffee elastic or inelastic? c) Based on your answer to a., if the price of coffee is increased by 10%, what will happen to the revenues from coffee? Carefully explain how you know. B. Suppose that the price elasticity of demand for wheat is known to be -0.75. Will a good wheat crop (which increases the supply of wheat) be likely to increase or decrease the revenues of farmers? Carefully explain. Answer: Part A: The initial price of a cup of coffee is $1.00, and at that price, 400 cups are demanded. If the price falls to $0.90, the quantity demanded will increase to 500. a. Calculate the (arc) price elasticity of demand for coffee: Ep = Q 2 − Q1 P 2 − P1 : (Q1 + Q 2) / 2 ( P1 + P 2) / 2
500 − 400 0.9 − 1 : (500 + 400) (1 + 0.9) 2 2

=

= -2.11 b. Based on the above results, the (arc) price elasticity of demand for coffee is 2.11 in absolute terms, the demand for coffee elastic. This is because the percentage decline in quantity demanded is greater that the percentage increase in price. In this case, a one percent change in price for a cup of coffee will cause 2.11% change in numbers of cups of coffee demanded. c. When the price of a cup of coffee is $1.00 and at that price, 400 cups are demanded. When the price falls to $0.90 the quantity demanded will increase to 500. The demand function for this situation can be expressed mathematically as: QD = f(P,X1, X2, X3, … Xn) (1) Where QD = Quantity demanded

P X1, X2, … Xn

= Price of a cup of coffee = other factors believed to affect the quantity demanded

We assume that other factors believed to be constant (It means that X1, X2, … Xn = 0). Therefore the function of quantity demanded should be: QD = f(P) (2) From the assumption of this question, with P0 = $1.00, Q0 = 400 and P1 = 0.90, Q1 = 500. We can establish the demand curve of coffee by using this curve function: QD Or = f(P) (P – P0)/(P1 – P0) (P – 400)/(500 – 400) -1,000P + 1,400 (4) (3)

(Q – Q0)/(Q1 – Q0) = (Q – 1)/(0.9 – 1) = =

Or

QD

At the price $0.90 and the quantity demanded is 500 cups. The total revenue is: TR1 TR1 TR1 = P1(Q1) = 0.90(500) = 450 USD

If the price of coffee is increased by 10%, it means that P2 = 1.10P1 = 1.10x0.90 = 0.99 The quantity demanded will be: Q2 Q2 Q2 = -1,000(P2) + 1,400 = -1,000(0.99) + 1,400 = 410

At the price $0.99 and the quantity demanded is 410 cups. The total revenue is: TR2 TR2 TR2 = P2(Q2) = 0.99(410) = 405.9 USD

Compare with TR1, we can see that TR1 > TR2. The degree of this difference is: % TR = (TR1 – TR2)/TR1

= (450 – 405.9)/450 = 0.098 = 9.8% Hence, when price of coffee increases 10%, the total revenue will decrease 9.8%.

Part B: In my opinion, the quantity supplied will increase. If the farmers have a good wheat crop, it leads an increase in price. Nevertheless, this price is higher than the equilibrium price and the quantity demanded for wheat will decrease. In the case of the price elasticity of demand for wheat is known to be -0.75 mean that that 1% change in price cause the quantity demanded to increase 0.75%. Hence, total revenues will fall, as the percentage change in quantity demanded will be less than the percentage change in price. References: Paul G. Keat, Philip K. Y. Young. (2006). Managerial Economics: Economic Tools for Today's Decision Makers (5 ed.). Upper Saddle River, New Jersey, 07458, USA: Pearson Education, Inc.

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