Question

Two goods, tea and coffee, are related in such a way that when the price of any one is varied, the demand for the other also varies. It was found that for consumers who are used to consume tea, the demand for tea fell from 240 kg to 220 kg when the price of coffee was decreased from its current price of Rs. 65/kg to Rs. 55/kg. Find out the cross elasticity of demand for tea and state the relationship between the two.

Answer 1

Cross Price elasticity of Tea = %CHange in Quantity of Tea / %Change in Price of Coffee = (220 / 240 - 1) / (55 / 65 - 1) = -0.0833/-0.154 = 0.542

So we see that with the fall in price of coffee, the demand for tea falls. This shows that people might be shifting to coffee when the price of coffee falls and this leads to drop in quantity demanded of tea. Thus Tea and Coffee are substitutes.

However, the percentage change in quantity of tea demanded is less than the percentage change of price of coffee. So they are not perfect substitutes.

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