Practice Problems on Elasticity

Not to be Turned In - For Your Own Study Use

(Answers at bottom of page - try to do these yourself before looking at the answers)

1.  Anna owns the Sweet Alps Chocolate store. She charges $10 per pound for her hand made chocolate. You, the economist, have calculated the elasticity of demand for chocolate in her town to be 2.5. If she wants to increase her total revenue, what advice will you give her and why?  Be able to explain your answer.

2.  If the cross elasticity of demand between peanut butter and milk is -1.11, then are peanut butter and milk substitutes or complements?  Be able to explain your answer.

3.  A 10 percent increase in income brings about a 15 percent decrease in the demand for a good. What is the income elasticity of demand and is the good a normal good or an inferior good?  Be able to explain your answer.

4.  If the price of a good increases by 8% and the quantity demanded decreases by 12%, what is the price elasticity of demand?  Is it elastic, inelastic or unitary elastic?

5.  Discount stores sell relatively elastic goods.  Ceteris paribus, explain why selling at a relatively low price is profitable for them?

ANSWERS

1.  Anna should lower her price.  Her price elasticity of demand for chocolate is elastic (greater than one) and therefore, when she lowers her price she will sell a lot more chocolate.  The greater quantity sold will make up for her lower price, increasing her total revenue.  In other words, she is selling at a lower price but making up for it in volume of sales.

2.  Peanut butter and milk are complements because a negative cross price elasticity of demand means that as the price of milk goes up, the demand for peanut butter goes down.  This would indicate that when the price of milk goes up, we buy less milk and we are also buying less peanut butter (so we must buy these together -- they are complements).

3.  -15%/10% = -.15/.10 = -1.5.  Remember the elasticity is always read as the absolute value or a positive number, so it is 1.5 (elastic, or greater than one).  The good is an inferior good because the sign is negative, indicating that an increase in income will bring a decrease in the demand for the good.

4.  -12%/8% = -.12/.08 = -1.5.  Again, drop the negative sign, so the elasticity is 1.5.  This means it is elastic (greater than one).

5.  It is profitable because with elastic goods, dropping the price lower can bring them a lot more business.  Therefore, at the low prices they can sell a large volume of goods, making up for the lower prices and bringing in more revenue (P x Q).