Question

When the price of tea increase from $ 8.00 to $10.00, the demand for tea decrease from 40 units to 20 units. The rise in the price of tea has increased the demand for coffee from 25 units to 35 units. Calculate the: i) Cross elasticity of demand ii) Price elasticity of demand (Provide the formula for each calculation and give proper steps) .Briefly describe your findings.

Answer 1

(i)

Cross-elasticity = (Change in Coffee demand / Average Coffee demand) / (Change in Tea price / Average Tea price)

= [(35 - 25) / (35 + 25)] / [(10 - 8) / (10 + 8)]

= (10 / 60) / (2 / 18)

= 1.5

Since Cross-elasticity > 0, Tea & Coffee are substitutes and 1% increase (decrease) in price of Tea will increase (decrease) the demand for Coffee by 1.5%.

(ii)

Price-elasticity (Ed) = (Change in Tea demand / Average Tea demand) / (Change in Tea price / Average Tea price)

= [(20 - 40) / (20 + 40)] / [(10 - 8) / (10 + 8)]

= (- 20 / 60) / (2 / 18)

= - 3

Since |Ed| > 1, demand for tea is elastic and 1% increase (decrease) in price of Tea will decrease (increase) its quantity demanded by 3%.