Question

You are the manager of a theater. At present the theater charges the same admission price of $8 to all customers, regardless of age. You propose a two-tier pricing scheme: $5 for children under the age of 12 and $10 for adults. You tell your supervisor that your proposal is likely to increase revenue. "What must be true about the price elasticity of demand if your proposal is to achieve its goal of raising revenue?

1) Explain the concepts of cross-price elastic of demand, using one of the examples in the table above. What does a positive or negative value indicate? When doing elasticity of demand what is the sign always for a normal good?

2)Explain the concepts of income elasticity using the one of the items in the table above. What does a positive value indicate? What about a negative value indicate?

3) When the price of Bob’s Coffee House increased by 8 percent, the quantity demanded of Alex’s Coffee House increased by 10 percent. What would be the cross- price elastic of demand between Bob’s & Alex’s coffee? What is the relationship between these two goods (are they compliments?)

4) Suppose the current price of oil is $90 a barrel and the quantity supplied is 800 million barrels per day. If the price elasticity of supply for oil in the short run is estimated at 0.5, use the midpoint formula to calculate the percentage change in quantity supplied when the price of oil rises to $98 a barrel.

Answer 1

The Answer to the First Question at Top:

Increasing price will increase revenue when the demand is inelastic (i.e. the absolute value of price elasticity of demand should be less than 1). This is because in the case of inelastic demand, the % fall in demand is lower than the % rise in price. So, the revenue goes up when the price is decreased. The opposite happens in the case of elastic demand. In case of elastic demand, increasing the price decreases revenue.

So, in this case the absolute value price elasticity of demand must be less than 1 i.e. the demand is inelastic.