ME Tutorial -6

Q1. If Alis income increases from

$36000 to $ 40000 and the amount
of donuts he consumes increases
from 52 per year to 86 per year .
Calculate the income elasticity of
Demand . What type of goods are
donuts for Ali ?
Q2. The price of tea increased from
$1.20 to $1.50 per box . The
quantity of scones demanded
changed from 10 units to 8 units .
Calculate
Cross
Elasticity
of
Demand and comment on the
relationship between the two goods
Q3. Times Media has estimated the
demand for its service to be given
by the following function:
Q = 9.83P-1.2A2.5Y1.6P01.4

Q = monthly sales in units; P =

price of the service in Rs; A =
promotional expenditure in
Rs000
Y = average income of the
market in Rs000; P0 = price
of home movies in Rs
The current price of Times Media is
Rs 60, promotional expenditure is
Rs 120,000, average income is Rs
28,000, and the price of home
movies is Rs 45.
Indicate whether the following
statements are true or false,
giving your reasons and making
the necessary corrections.
a. If Times Media increases its price
this will reduce the number of its
customers.
b. If Times Media increases its price
this will reduce its revenues.
c. Peoples expenditure on the cable
TV service as a proportion of their
income will increase when their
income increases.
d. If Times Media increases its price
this will increase the sales of
home movies.
e. Home movies are a substitute
for cable TV.

f. A

5% increase in income will

increase demand by 16%.
g. A 10% increase in price will
reduce demand by 12 %.
h. Current sales are over a million
units a month.

ME Tutorial -6
Q1. If Alis income increases from
$36000 to $ 40000 and the amount
of donuts he consumes increases
from 52 per year to 86 per year .
Calculate the income elasticity of
Demand . What type of goods are
donuts for Ali ?
Q2. The price of tea increased from
$1.20 to $1.50 per box . The
quantity of scones demanded
changed from 10 units to 8 units .
Calculate
Cross
Elasticity
of
Demand and comment on the
relationship between the two goods
Q3. Times Media has estimated the
demand for its service to be given
by the following function:
Q = 9.83P-1.2A2.5Y1.6P01.4

Q = monthly sales in units; P =

price of the service in Rs; A =
promotional expenditure in
Rs000
Y = average income of the
market in Rs000; P0 = price
of home movies in Rs
The current price of Times Media is
Rs 60, promotional expenditure is
Rs 120,000, average income is Rs
28,000, and the price of home
movies is Rs 45.
Indicate whether the following
statements are true or false,
giving your reasons and making
the necessary corrections.
a. If Times Media increases its
price this will reduce the
number of its customers.
b. If Times Media increases its
price this will reduce its
revenues.
c. Peoples expenditure on the
cable TV service as a proportion

of their income will increase

when their income increases.
d. If Times Media increases its
price this will increase the sales
of home movies.
e. Home movies are a substitute
for cable TV.

f. A 5% increase in income will

increase demand by 16%.
g. A 10% increase in price will
reduce demand by 12 %.
h. Current sales are over a million
units a month.

Solutions

Ans 1 : Income Elasticity of Demand is 4.7 , Normal / Luxury Goods

Ans 2 : Cross Elasticity of demand is -1 , complementary goods
Ans 3 :
a) True; customers and quantity demanded are synonymous in this case, and there is an inverse
relationship between Q and P (law of demand) and as seen by the negative price elasticity.
b) Important derivation below;
Consider a demand function, Q = aPb
Then,
Price elasticity of demand (PED) will be:

Now solution to the statement;

True; demand is elastic (using above derivation, PED in this case turns out to be 1.2 or -1.2, remember in
case of PED negative sign is ignored always), since the PED is greater than 1 in absolute magnitude.
Therefore, an increase in price causes a greater than proportional decrease in quantity demanded and a
fall in revenue.

c) True; this is because the YED (Income elasticity of demand) is greater than 1 (using above derivation,
YED in this case turns out to be 1.6), indicating that cable TV is a luxury product. Note that the statement
would be false if the good were a staple. For staples, although expenditure on the product increases as
income increases, expenditure as a proportion of income falls, since expenditure rises more slowly than
income.

d) False; the two products are complementary, shown by the CED (Cross elasticity of demand; using
above derivation, CED in this case turns out to be -1.4) being negative; therefore an increase in the price of
one product will reduce the sales of the other. It appears therefore that home movies is a cable channel.

e) False; the two products are complementary, shown by the CED being negative.

f) False; YED=1.6; therefore using the simple elasticity formula (reasonably accurate for small changes)
the change in demand will be
g) True; change/reduction in demand will be
h) False; current sales are given by