CHAPTER 2: DETERMINANTS OF PRICE

Elasticity

Theory

Choose the definition for each key term.

Elasticity
Price elasticity of demand
Elastic
Inelastic
Total revenue
Income elasticity of demand
Cross price elasticity of supply
Normal good
Inferior good

1. A measure of how much the quantity demanded of a good responds to a change in

consumers’ income.
2. When the quantity demanded or supplied responds substantially to a change in one of its
determinants.
3. A good characterized by a negative income elasticity.
4. A measure of the responsiveness of the quantity demanded or quantity supplied to one
of its determinants.
5. A good characterized by a positive income elasticity.
6. A measure of how much the quantity supplied of a good responds to a change in the
price of that good.
7. When the quantity demanded or supplied responds only slightly to a change in one of its
determinants.
8. The amount paid by buyers and received by sellers of a good computed as P x Q.
9. A measure of how much the quantity demanded of a good responds to a change in the
price of that good..
10. A measure of how much the quantity demanded of one good responds to a change in the
price of another good. .

Practice Problems

1. For the following 3 cases, calculate the cross elasticity of demand and identify the type of
relationship between two products.

a. The quantity demanded for Good A increases from 40 units to 50 units as the price of
Good B increases from RM0.20 to RM0.30

Coefficient: _____________

Relationship: ____________

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 b. The quantity demanded for Good A decreases from 2000 units to 1000 units as the
price of Good B increases from RM10 to RM15 a unit

Coefficient: _____________

Relationship: ____________

c. The quantity demanded for Good A remains 400 units as price of Good B increases
from RM30 to RM35 a unit.

Coefficient: _____________

Relationship: ____________

2. For each pair of goods listed below, which good would you expect to have the more
elastic demand? Why?

a. Cigarettes, a trip to Florida over spring break

b. An AIDS vaccine over the next month, an AIDS vaccine over the next 10 years.
c. Insulin, aspirin

3. For each pair of goods listed below, which good would you expect to have the more
elastic supply? Why?

a. Televisions, beach front property

b. Crude oil over next week, crude oil over the next year.

4. The table below provides the demand schedule for motel rooms at Small Town Motel.
Use the information provided to complete the table. Answer the following questions
based your responses in the table. Use the midpoint method to calculate the percentage
changes used to generate the elasticities.

Price Quantity Total % Change %Change Elasticity

(RM) Demanded Revenue in price in Quantity
20 24
40 20
60 16
80 12
100 8
120 4

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 a. Over what range of prices is the demand for motel rooms elastic? To maximize total
revenue, should Small Town Motel raise or lower the price within this range?
b. Over what range of prices is the demand for motel rooms inelastic? To maximize total
revenue, should Small Town Motel raise or lower the price within this range?
c. Over what range of prices is the demand for motel rooms unit elastic? To maximize
total revenue, should Small Town Motel raise or lower the price within this range?

5. Suppose the New Straits Time Newspaper estimates that if it raises the price of its
newspaper from RM1 to RM1.50 that its subscribers will fall from 50,000 to 40,000.
a. What is the price elasticity of demand for the New Straits Time Newspaper when
elasticity is calculated using the midpoint method?

b. If the New Straits Time Newspaper only concern is to maximize total revenue, should
it raise the price of a newspaper from RM1 to RM1.50? Why?

6. State the correct type of relationship between the two commodities

A B Relationship
Pepsi Coke
Bus Taxi
Bread Butter
Tea Sugar

a. With diagram, explain the effects on price and quantity of good B if price of good A
increase.

7. The following table shows the relationship between Good X, Good Y and consumers’
income.

PX QdX QdY I
(RM)
150 25 60 2000
130 30 55 1800
110 35 50 1600
90 40 45 1400
70 45 40 1200

a. Calculate the price elasticity of demand for Good X when its price increases from
RM110 to RM130
b. Calculate the cross elasticity of demand for Good Y when the price of Good X falls
from RM110 to RM70
c. Calculate the income elasticity of demand for Goods X and Y when consumer’s
income increases from RM1800 to RM2000
d. Based on your answer in (c), what type of Good X and Y?

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8. Table below shows the relationship between price of Good X and quantity demanded for
goods L and N

PX 10 9 8 7
QL 50 46 40 37
QN 9 17 20 24

a. Calculate the cross elasticity between good X and L and good X and N when the price
of X falls from RM9 to RM8
b. Determine the relationship between goods
i. X and L
ii. X and N

Short Answer questions

1. What are the four major determinants of the price elasticity of demand?
2. If demand is inelastic, will an increase in price raise or lower total revenue? Why?

3. If the price of soda doubles from RM1.00 per can to RM2.00 per can and you buy the
same amount, what is your price elasticity of demand for soda and is it considered elastic
or inelastic?

4. If the price of Pepsi increase by one cent and this induces you to stop buying Pepsi and
switch to Coke, what is your price elasticity of demand for Pepsi and is it considered
elastic or inelastic?

5. Suppose your income rises by 20% and your quantity demanded of eggs falls by 10%.
What is the value of your income elasticity of demand for eggs and are eggs normal or
inferior goods to you?