Answer to Question #211210 in Microeconomics for Ruchi

Question

The general linear demand function for good X is estimated to be Q = 250000-500P-1.5 M – 240 PRWhere, P = price of good X, M is average income of consumers who buy good X, and PR   is the price of related good R. The values of P, M, and PR are expected to be $200, $60000 and $100.  Use these values at this point on demand to make the following computations.

1. Calculate the price elasticity of demand E. At this point on the demand for X, is demand elastic, inelastic, or unitary elastic? How would increasing the price of X affect total revenue? Explain  (5 Marks)
2. Calculate the income elasticity of demand EM. is good X normal or inferior? Explain how a 4 percent increase in income would affect demand for X, all other factors affecting the demand for X remaining the same. (5 Marks)

Answer 1

1:

The price elasticity of demand is zero at point "E" hence it is inelastic. Therefore the elastiity of demand is zero and when prices rises, there is also increase in total revenue.

2:

%Change in quantity demanded = (36000-32400)/36000 = 10%

% Change in income = 4%

Income elasticity of demand = 10%/4% = 2.5

Em = 2.5

Good X is an inferior good because with the income increasing, its demand is decreasing. Inferior goods have a negative income effect.