introduction to agribusnes[AEA101]QUESTIONS AND ANSWERS

Summary of Elasticity

Less than 1	Equal to 1	Greater than 1
Inelastic	Unitary elastic	Elastic
Eg. A 10 % increase in price will lead to a 5 % decrease in quantity demanded.	Eg. A 10 % increase in price will lead to a 10 % decrease in quantity demanded.	Eg. A 10 % increase in price will lead to a 20 % decrease in quantity demanded.
Eg. Necessity/Petrol		Eg. Foreign holiday
Price increase will lead to total revenue increase.	Price increase will lead to no change in total revenue.	Price decrease is needed to increase total revenue.

SIGN	PED	YED	CED
-	Obeys the law of demand	Inferior/giffen	Complementary
+	Does not obey the law of demand	Normal	Substitute

Substitution Effect + Income Effect = Price Effect

(Effect of a price reduction)

	Substitution Effect	Income Effect	Price Effect
Normal Good	Positive Demand increases as the good is relatively cheaper.	Positive Demand increases as real income rises.	Quantity demanded increases Because both effects are positive
Inferior Good	Positive  Demand increases as the good is relatively cheaper.	Negative  Demand declines as real income rises.	Quantity demanded increases Because the positive substitution effect is stronger than the negative income effect.
Giffen Good	Positive Demand increases as the good is relatively cheaper.	Negative  Demand declines as real income rises.	Quantity demanded decreases Because the negative income effect is stronger than the positive substitution effect because a large proportion of income is spent on giffen goods. .

ELASTICITY OF DEMAND

The English economist Alfred Marshall (1842-1924) was one of the first economists to use the use of mathematics to illustrate economic theory.  He was the first person to apply the term “elasticity of demand” to explain the reaction of demand to small changes in prices. Producers that wish to maximize profits and finance ministers that wish to maximize tax revenue use elasticity measurements to assess the affect of price changes on total revenue. Students should pay particular attention to signs and be precise and specific and when answering questions on elasticity. Be careful with definitions. For example it is not good enough to say that something is a normal good because it has a minus sign or because as price goes up demand goes down. In the first instance you must state that quantity demanded goes down and in the second instance you must state that a normal good obeys the law of demand. Consequently attention to detail is imperative in order to achieve a good grade in the Leaving Certificate economics exam.

2012 SQ 5

2012 Q 1 (b)

2010 SQ 3. A consumer spends €200 monthly on Product A when its price is €2 and continues to spend €200 monthly when its price increases to €2.50. Calculate the consumer’s price elasticity of demand. (See Formulae and Tables Booklet p.28) Show all your workings and explain your answer.

Workings:

Quantity 1: €200 / €2 = 100 units.

Quantity 2: €200 / €2.50 = 80 units.

- 20   x   €2 + €2.50   =  ( 4.50) = -  1.0

  50         100 + 80          (180)

Explanation

This good has a minus sign, which means when price goes up quantity demanded goes down and therefore it obeys the law of demand.

This good is unit elastic because PED = 1 which means that the percentage change in demand is equal to the percentage change in the price of the good.

2010 Q 1. (b) (i)

Outline four factors which affect price elasticity of demand (PED).

1. The availability of close substitutes.

• When a good has a close substitute and its price is increased the demand for the good will be elastic because people will switch to the cheaper substitute.
• Where a good has no substitutes and its price is increased there is no substitute to switch to and so it will be inelastic.
• The closer the substitutability between goods the more consumers will tend to switch their purchasing behaviour in response to a change in relative prices and thus the greater will be PED.

2. Is the commodity a luxury or necessity?

• It is not vital that one should possess luxuries and therefore the PED for them will be relatively elastic.
• Necessities are vital for life – people must buy them even when their price is increased, so their PED will be relatively inelastic.

3. The proportion of income which is spent on the commodity.

• In general the greater the proportion of income which is spent on a good, the more elastic the demand for it is likely to be, in response to a change in its own price. A rise of 50% in the price of a box of matches is unlikely to have a significant effect on its demand.

4. The durability of the commodity.

• The more durable the commodity, the more elastic is the demand for it likely to be in response to a change in its own price.
• If products such as motorcars increase in price, it is likely that the public will extend the life of their existing model and postpone the purchase of a replacement.

 2010 Q 1. (b) (ii)

The PED for the soft drink ‘Quencher’ has been calculated at  -3.8

Using your knowledge of PED, explain the economic meaning of this figure.

Sign: Is minus therefore if price goes up quantity demanded will go down, therefore it obeys the law of demand.

Number: Is greater than one, therefore the good is elastic. This means that the percentage change in quantity demand is greater than then the percentage change in price.  When price rises and the demand falls by a greater percentage this indicates that the good is not a necessity and therefore it is a luxury.

2010 Q 1. (c) Many health advisors wish to reduce the consumption of soft drinks.  Advise the Minister for Health and Children on possible economic actions that the Government could take to reduce the consumption of soft drinks.

1. Increase taxes on soft drinks

By increasing indirect taxes (e.g. VAT) the price will increase which may cause demand to fall.

2. Education / awareness campaign

The government could increase spending on advertising campaigns to

raise awareness of the problems which may result from the consumption of soft drinks.

It could insist on more stringent product labeling.

3. Introduce legislative changes

The government could ban the sale of soft drinks in schools and colleges / ban their sale in vending machines. It could place a quota on imports of such drinks.

4. Subsidise the price of substitute goods

By doing this the prices of substitute goods may be more attractive and this may lead to a drop in the demand for soft drinks e.g. the subsidisation of milk or fruit juices in schools.

2009 Q 1. (b) (i)

Define income elasticity of demand and price elasticity of demand.

Income Elasticity of Demand (YED)

Measures the percentage / proportionate change in the demand for a good caused by the percentage / proportionate change in income.

YED for a normal good is positive because as Y increases, quantity demanded increases.

YED for an inferior good is negative because as Y increases, quantity demanded decreases.

YED for a giffen good is negative because as Y increases, quantity demanded decreases.

Price Elasticity of Demand (PED)

Measures the percentage / proportionate change in the demand for a good caused by the percentage / proportionate change in the price of that good.

• Goods that obey the law of demand have a negative (-) PED.
• Goods that do not obey the law of demand have a positive (+) PED.

2009 (b) (ii)

 Which figure stated below is most likely to represent each of the following:

• Income elasticity of demand for low price cuts of meat;

• Income elasticity of demand for Apple iPhones;

• Price elasticity of demand for Petrol.

         - 1.6              - 0.1                    + 4.3

Demand for low cut meats is -1.6 because 

• It is an inferior good and has a negative YED
• Low price cuts of meat is not a necessity so it is income elastic (>1)

Demand for Apple iPhones is = 4.3 because

• Apple iPhones are a normal good so they have a positive YED.

• Apple iPhones are a luxury so they are income elastic (>1).

Demand for Petrol is  –0.1 because

• Petrol obeys the law of demand, as price increases, quantity demanded decreases so it has a negative PED.
• Petrol is a necessity so it is price inelastic (<1).

2009 Q 1. (c) Assume Income elasticity of demand for games consoles is + 2.5 and total sales in 2008 were 100,000 units.  Calculate the expected total sales for the year if consumers’ incomes are expected to fall by 8% in 2009. Show your workings.

• If income decreases by 8% then sales will decrease by (8% x 2.5) = 20%.
• Sales will fall by 20% of 100,000 units = 20,000 units.
• Sales in 2009 will equal 100,000 – 20,000 = 80,000 units.

2008 Q 1. (a) (i) Explain with the aid of an example, the ‘Law of Demand’.

The Law of Demand states that an increase in price leads to a decrease in quantity demanded, or a decrease in price leads to an increase in quantity demanded.

Example: If price of a bar chocolate increased by 5c per bar then quantity demanded or purchased would fall. This is why normal goods face a downward facing demand curve.

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2008 Q 1. (a) (iii) Using this data, calculate the price elasticity of demand when price changes from €40 to €50. (Show all your workings). For this price change, is demand for MP3 Players elastic or inelastic? Explain your answer.

ΔQ x P1 + P2

 ΔP    Q1 + Q2

- 20   x  €40 + €50 (90)

                                                           10       60 + 40 (100)

- 1.8

Price Elastic because the PED is greater than 1

2007 SQ 3. Consumers buy 50 units of a product when the price is €1.50. When the price is reduced to €1 consumers buy 90 units. Using an appropriate formula, calculate the consumers’ price elasticity of demand. Show your workings and explain your answer.

Workings

     40          x    1.50 + 1.00 [2.50] =  −  1.43

− 0.50                 50 + 90 140

Exlanation

PED is elastic because the PED is greater than 1.

The PED is negative, therefore if price goes down, demand goes up, therefore it obeys the law of demand.

2006 Q 1. (a) For analytical purposes economists make certain assumptions about consumer behaviour. State and explain FOUR principal assumptions.

1. The consumer has a limited income.

The consumer’s income is not large enough to satisfy his/her needs and wants, Therefore the consumer must choose between those goods he wishes to buy.

2. The consumer aims to gets maximum satisfaction / utility from that income.

A consumer will spend his/her limited income in such a way that he/she will achieve the most satisfaction / best value for money.

He/she will obey the Equi-Marginal Principal of Consumer Behaviour.

3. The consumer acts rationally.

The consumer acts in that manner consistent with his preferences. If the person sees an identical commodity priced differently in two adjoining shops they will but it at the lower price.

4. The consumer is subject to the law of diminishing marginal utility.

As a consumer consumes additional units of a good his/her marginal utility for this good will eventually decline.

2006 Q 1. (b) A manufacturer of three different products calculates the price elasticity of demand for each product as follows:

Product X: -1.5       Product Y: -1.0     Product Z: -0.3

The company wishes to maximise its revenues. Explain in respect of each of these products, what change, if any, the company should make in the prices currently being charged to enable it to achieve its aim.

Product X: -1.5      

Elastic because PED > 1

Decrease price and demand will increase.

This will increase total revenue because the % ↑ in demand exceeds the % ↓ in price

Product Y: -1.0    

Unit Elastic because PED = 1

Leave price unchanged because:  the % Δ in demand equals the % Δ in price

Total revenue will remain unchanged

Product Z: -0.3

Inelastic because PED < 1

Increase price  even though demand will fall.

This will increase total revenue because: the % ↑ in price exceeds the % ↓ in demand.

2006 Q 1. (c) A consumer buys 10 units of Good A when the price of Good B is €5.

When the price of Good B rises to €6 (the price of Good A remaining unchanged) the consumer buys 14 units of Good A.

2006 Q 1. (c) (i) Define cross elasticity of demand.

Cross elasticity of demand

Measures the percentage / proportionate change in the demand for one good,

caused by the percentage / proportionate change in the price of other goods.

2006 Q 1. (c) (ii) Using an appropriate formula, calculate this consumer’s cross elasticity of demand for Good A. Show your workings.

Δ QA         X      PB1 + PB2

Δ PB                  QA1 + QA2

+ 4        X           5 + 6       =     (44)

+ 1                     10 + 14           (24)         =     + 1.83

2006 Q 1. (c) (iii) Is Good A a substitute for, or a complement to, Good B? Explain your reasoning.

Good A is a substitute good:

The answer has a has a + sign. This means that when the price of Good B increased the consumer switched from Good B to the cheaper alternative, Good A so the quantity demanded of Good A increased.(+ = both move in the same direction.)

2004 Q 2. (a) Define the following types or degrees of price elasticity of demand:

(i) Perfectly elastic demand;

(ii) Perfectly inelastic demand;

(iii) Elastic demand;

(iv) Unitary elastic demand.

(i) Perfectly elastic demand.

• Occurs when consumers are prepared to buy all they can of a good at a given price, while any increase in price above this given price will result in quantity demanded to fall to zero.
• This is represented by a horizontal demand curve.

(ii) Perfectly inelastic demand.

• The percentage change in price causes no change in the quantity demanded.

• This is represented by a vertical demand curve.

(iii) Elastic demand

• The percentage change in demand is greater than the percentage change in the price of the good.

(iv) Unitary elastic demand.

• The percentage change in demand is equal to the percentage change in the price of the good.

2004 Q 2. (c) A consumer spends €120 per month on a product when its unit price is 80c, and continues to spend €120 per month on this product when its unit price increases to €1.

(i) Using the formula in your tables, calculate the consumer’s price elasticity of demand. Show all your workings.

Quantity demanded of the product:

When the unit price is 80c  €120/0.80   = 150 units

When the unit price is €1 €120/€1 = 120 units

Calculate the Price Elasticity of Demand:

Answer

-   30      x   0.80c + €1

+ 0.20c        150 + 120

  - 30      x     1.80

+ 0.20           27           =           - 1.00

(ii) Is demand for this product elastic, inelastic or unitary elastic?

Unitary elastic: as it is = 1

(iii) Should the seller make any changes in the selling price of this commodity to increase overall revenue? Explain your answer.

Price Change: The price of the product should be left unchanged.

Effect on Demand: Hence the quantity demanded will remain unchanged.

Effect on Revenue: Thus there will be no effect on the revenue of the firm.

Reason:  Because the percentage change in quantity demanded equals the percentage change in the price of the product.

2003 Q 2. (b) When the price of Good X is €27, the quantity demanded of Good Y is 1,200 units. When the price of Good X falls to €23 (the price of Good Y unchanged) the quantity demanded of Good Y falls to 800 units.

(i) Using the cross elasticity of demand formula, calculate the cross elasticity of demand for Good Y. Show all your workings.

- 400      X      27 + 23          (50)

  - 4            1200 + 800    (2000)    =    + 2.5

(ii) Is Good Y a substitute for or complement to Good X? Explain your choice.

Good Y is a substitute good.  This means that as the price of good X decreased, consumers switched from Good Y to the cheaper alternative, Good X.

2003 Q 2. (c) A firm has the following price elasticities of demand for two goods, Good X and Good Y:

Good X …..- 2.0      Good Y …..- 0.5

What changes, if any, should the firm make in the selling price of each of the goods to increase overall revenue. Explain your answer.

Good X  …..-2.0

Normal good because – sign, therefore if price increases, quantity demanded decreases.

Elastic because PED > 1

The firm should decrease price and demand will increase

This will increase total revenue because the % ↑ in demand exceeds the % ↓ in price

Good Y …..- 0.5

Normal good because – sign, therefore if price increases, quantity demanded decreases.

Inelastic because PED < 1

The firm should Increase price even though demand will fall.

This will increase total revenue because: the % ↑ in price exceeds the % ↓ in demand

2003 Q 3 (c)  A consumer spends all income on two goods, Good A and Good B. Both goods are normal goods but they are not complementary goods. The price of Good A is reduced and the price of Good B remains unchanged. The consumer continues to

spend all income on the two goods. Distinguish between the substitution effect

and the income effect of the price reduction in Good A.

Substitution Effect

Demand for good A increases as it is now relatively cheaper.

Hence the consumer is getting increased marginal utility for this good.

Income Effect

Demand for good A increases as the consumer has additional income due to the reduction in the price of good A.

As good A is a normal good the demand for this good will increase.

2002 (b) (i) “Income elasticity of demand is usually positive but sometimes negative”.

Explain, giving examples, the meaning of this statement.

Positive YED means;

That as income rises, quantity demanded rises (+ = both move in the same direction).

These goods are nomal goods, eg a foreign holiday.

Negative YED means;

That as income rises, quantity demanded falls (- = both move in the opposite direction).

These goods are inferior goods, eg. cheap cuts of meat.

2002 Q 3. (b) (ii) A consumer spends 40% of income on a certain good. After the consumer’s income doubles (everything else remaining unchanged), only 30% of income is spent on the good. State whether this good is a normal or inferior good and explain your answer.

At a first glance students might assume that this is an inferior good as when income doubled the percentage spent on the good went from 40% down to 30%.  However 30% of a bigger number may result in more being spent in monetary terms.  So, it is necessary to work this question out using an example.

Let the consumer’s income = 100 euro

When income = 100 euro the consumer spends 100 X 40 % = 40 euro

When income doubles to 200 euro the consumer spends 200 x 30% = 60 euro

So when income increased, quantity demanded also increased which indicates that it is a normal good.

2002 Q 3. (c) Which of the figures stated below is likely to represent:  (30 m)

(i) Income elasticity of demand for potatoes;

(ii) Income elasticity of demand for designer clothes;

(iii) Price elasticity of demand for airline seats.

                                                                                             

-2.8,          -0.1,           + 2.5

2002 Q 2. (d) Income elasticity of demand for a good is +1.8 and sales in Year 1 are 20,000 units. If consumers’ incomes are expected to rise by 5% in Year 2, calculate the expected level of sales. Show your workings.

2001 Q2. (b) A consumer buys 80 units of a good when the price is 1.50. The price increases to 1.75  and the consumer now buys 70 units.

(i) Using the formula in your tables, calculate the consumer’s price elasticity of demand. Show all your workings.

-10                   1.50 + 1.75           3.25

+25                     80 + 70              1.50          =     -0.866

(ii) Is demand for this good elastic, inelastic or unitary elastic?

• The demand for this good is inelastic.

(iii) The seller of the above good wishes to earn maximum revenue. What changes, if any, should the seller make in the selling price of the good to earn maximum revenue? Explain your answer.

Answer

The seller should increase the price.

Explanation:

Even though an increase in price will lead to a decrease in  quantity demand (-sign denotes that this good obeys the law of demand), the percentage increase in price will be greater than the percentage decrease in quantity demanded (the number is less than one so the good is inelastic). Hence total revenue will increase.