Elasticity of Demand and Supply

TOPIC: ELASTICITY OF DEMAND AND SUPPLY

TABLE OF CONTENT

PAGE

I PROBLEM

II RELEVANT THEORIES

III SOLUTION

i. QUESTION 1

ii. QUESTION 2

iii. QUESTION 3

IV APPENDIX

II RELEVANT THEORIES

1. The Income elasticity of demand ( QUESTION 1):

* Measure the responsiveness of a change in quantity demanded of some commodity to a change in income.

2. Arc Income elasticity (QUESTION 1):

Income elasticity between 2 income levels

3. Income elasticity (εy) (QUESTION 1):

* εy > 0 (positive), refers to normal goods

0< εy < 1 necessity good

εy > 1 (luxury good)

* εy < 0 (negative), refers to inferior goods

III SOLUTION

i. Question 1

Calculate the income elasticity of demand and explain.

Solution:

Given:

Q0= 10,500 potted plants, Y0 = $34,200

Q1= 7,500 potted plants, Y1= $30,600

By using Arc Income Elasticity formula:

Interpretation:

The income elasticity is 3.0. This means that a 10% increase in income will lead to 30% increase in the quantity demanded. As the value for income elasticity is greater than 1 (Ey>1), this implies that potted plants sell in Interior’s landscape is a luxury good.

ii.

Question 2

Given the projected fall in income, the sales manager believes that current volume of 10,500 plants could only be maintained with a price cut of $5 per unit. On this basis, calculate the price elasticity of demand and explain

Solution:

i) The market in Equilibrium

P

Q

D

$25

10500

S

ii) When income dropped, the demand curve shift to leftward

P

Q

D

$25

10500

D

7500

iii) As Sales manager wish to maintain the sales at 10,500 plants, he reduced the price to $20

P

Q

$25

10500

D

7500

$20

Given:

Q0= 7,500 potted plants, P0 = $25

Q1= 10,500 potted plants, P1= $20

Interpretation:

The income elasticity is -1.53 which is a negative value. This means that when price of greenery DECREASE by 10%, the...