ECO10004: ECONOMIC PRINCIPLES

WEEK 4_TUTORIAL QUESTIONS

Key concepts: Elasticity, Price Elasticity of Demand, Elastic, Inelastic, Cross-price Elasticity
of Demand, Income Elasticity of Demand.

Short-answer Questions
Question 1) In high-income countries (such as Australia), the price elasticity of demand for
cigarettes is estimated to be about -0.4.
Which of the following statements best describes this price elasticity of demand?
a. When the price of cigarettes increases by $1, the demand for cigarettes decreases by
0.4 units.
b. When the price of cigarettes increases by $1, the quantity demanded for cigarettes
decreases by 0.4 units.
c. When the price of cigarettes increases by 1%, the demand for cigarettes decreases by
0.4%
d. When the price of cigarettes increases by 1%, the quantity demanded for cigarettes
decreases by 0.4%.
Clearly explain why the answer of your choice is correct while the other three alternatives
are incorrect.
Is the quantity demanded for cigarettes in Australia sensitive or insensitive to a change in
price?
Do you think the demand for cigarettes in Australia is price elastic or price inelastic?
Clearly explain why.
Answer:
The unit of the increase/decrease in cigarettes price and quantity demanded should be %
and it should be “quantity demanded” instead of demanded => A
Because p = I-0.4I = 0.4 < 1
Quantity demanded is insensitive
Demand is inelastic

Question 2) Aran owns a bookstore. He is currently selling 40 copies per day of the latest
J.K.Rowling novel (a sequel to the Harry Potter series) at a price of $35. Aran is thinking
of lowering the price to $25. He believes this will increase the quantity sold to 50 books
per day.
a. Using the mid-point formula and based on the data above, calculate the price elasticity
of demand for the latest J.K.Rowling novel in Aran’s bookstore
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 b. Is the demand for the novel elastic or inelastic?
c. Should Aran go ahead and reduce the selling price? How will that decision affect
Aran’s total revenue earned from this novel?

Answer:
Q1 = 40 Q2 = 50
P1 = $35 P2 = $25

a) Applying Midpoint formula:

Q 2−Q1 50−40 2
%Q = = 0.2
(Q 2+Q1)/2 (50+ 40) /2 9

P 2−P 1 25−35 −1 % Q −0.2

%P = = −0.3 p= = −0. 6
( P 2+ P1)/2 (25+35)/2 3 %P 0. 3

b) Absolute value: p = I-0.6I = 0.6 < 1 => Inelastic

Question 3) One of the questions in a micro online test is as follows:

“The price elasticity of demand for low-fat milk in Australia is estimated at -2.07
(Sharma et al 2014).
Do you think the demand for low-fat milk in Australia is price elastic or price inelastic?”
In response to the above question, Vu (a 1st year student) writes the following answer:
“The price elasticity of demand for low-fat milk is -2.07. It’s a negative number, thus, it’s
lower than 0. Since it’s lower than 0, it’s definitely lower than 1. Therefore, the demand
for low-fat milk in Australia is inelastic.”
Do you agree or disagree with Vu’s answer above? Clearly explain why.
Answer:

Disagree because p must be in absolute value => p = I-2.07I = 2.07 > 1 => Elastic
Question 4) Harrison owns a dairy farm in Western Victoria. There are about 1,500 dairy
farms in the same region. All dairy farms here, Harrison’s included, sell milk to at the
price of 50 cents per litre. The buyers are Woolworths and Coles, the two biggest
supermarket chains in Australia.
Last month, Harrison decided to raise his price to 55 cents per litre while his competitors
kept the price unchanged. After raising his price, Harrison noticed that his buyers stopped
doing business with him. Consequently, Harrison’s sales last month crashed to zero.
What you can say about the price elasticity of demand for Harrison’s milk? Clearly
explain.

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 How would you illustrate the demand curve for Harrison’s milk on a graph?
Note: This question does not focus on the price elasticity of demand for milk overall. It
concentrates on the price elasticity of demand for milk supplied by Harrison in particular.
Answer:
In this case, the demand for Harrison’s milk is perfectly elastic
Q1 = ∞ Q2 = 0
P1 = 50 cents P2 = 55 cents

Q 2−Q 1 0−∞
Q 2+Q 1 ∞+ 0
%Q 2 2
p= = = =∞ ¿> Perfectly Elastic
% P P 2−P 1 55−50
P 2+ P 1 55+ 50
2 2

Question 5) For each pair of products below, determine which product would have a
higher price elasticity of demand (in absolute value). Refer to the list of determinants in
the lecture slides, point out which determinant is relevant in each case.
a. Drugs for cancer treatment and Lacoste polo shirts
b. Petrol (in the short run) and Petrol (in the long run)
c. Petrol and Domino’s Pizza
Pick the following pair of products “Drugs for cancer treatment” and “Lacoste polo
shirts”.
Draw the demand curve for each of them, then compare. What can you say about the
difference in the demand curve between cancer drugs and Lacoste polo shirts? Explain.
Answer:
a) Drugs for cancer (necessity) and Lacoste (luxury)

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b) Petrol (in the short run) (necessity) and Petrol (in the long run) (luxury)
c) Petrol and Domino’s Pizza (depend on which one has more subsitutions=> that one is less
necessity and vice versa)

As the chart below, we can see that because drugs are necessity item so the demand is
inelastic => the line is steep
The case of Lacoste, the item is luxury so it is more elastic => the line is flat

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