Question 5:

A. The initial price of a cup of coffee is $1, and at that price, 400 cups aredemanded.
If the price falls to $0.90, the quantity demanded will increase to 500.a) Calculate the
(arc) price elasticity of demand for coffee.b) Based on your answer, is the demand
for coffee elastic or inelastic?c) Based on your answer to a., if the price of coffee is
increased by 10%,what will happen to the revenues from coffee? Carefully explain
how youknow.B. Suppose that the price elasticity of demand for wheat is known to
be -0.75. Will agood wheat crop (which increases the supply of wheat) be likely to
increase ordecrease the revenues of farmers? Carefully explain.
Answer:
Part A:
The initial price of a cup of coffee is $1.00, and at that price, 400 cups aredemanded.
If the price falls to $0.90, the quantity demanded will increase to 500.a. Calculate
the (arc) price elasticity of demand for coffee:
2 / )21(12
QQQQ Ep
+=
:
2 / )21(12
PPPP
+

=
+
5 0 0 4 0 0 ( 5 0 0 4 0 0 ) 2
:
+
0 . 9 1 ( 1 0 . 9 ) 2
= -2.11b. Based on the above results, the (arc) price elasticity of demand for coffee
is 2.11 inabsolute terms, the demand for coffee elastic. This is because the
percentage decline inquantity demanded is greater that the percentage increase in
price. In this case, a onepercent change in price for a cup of coffee will cause 2.11%
change in numbers of cupsof coffee demanded.c. When the price of a cup of coffee
is $1.00 and at that price, 400 cups are demanded.When the price falls to $0.90 the
quantity demanded will increase to 500.The demand function for this situation can be
expressed mathematically as:
Q
D
= f(P,X
1
,X
2
,X
3
,X
n
) (1)
Where Q
D
= Quantity demanded

P = Price of a cup of coffeeX

1
,X
2
,X
n
= other factors believed to affect the quantity demandedWe assume that other
factors believed to be constant (It means that X
1
,X
2
,X
n
= 0).Therefore the function of quantity demanded should be:
Q
D
= f(P) (2)
From the assumption of this question, with P
0
= $1.00, Q
0
= 400 and P
1
= 0.90, Q
1
=500. We can establish the demand curve of coffee by using this curve function:Q
D
= f(P)Or (Q Q
0
)/(Q
1
Q
0
) = (P P
0
)/(P
1
P
0
)
(3)
(Q 1)/(0.9 1) = (P 400)/(500 400)Or Q
D
= -1,000P + 1,400
(4)
At the price $0.90 and the quantity demanded is 500 cups. The total revenue is:TR
1
=P
1
(Q
1
)TR
1
= 0.90(500)TR
1
= 450 USDIf the price of coffee is increased by 10%, it means that P
2
= 1.10P
1
= 1.10x0.90 = 0.99The quantity demanded will be:Q
2
= -1,000(P
2
) + 1,400Q
2
= -1,000(0.99) + 1,400Q
2
= 410At the price $0.99 and the quantity demanded is 410 cups. The total revenue
is:TR
2
=P
2
(Q
2
)TR
2
= 0.99(410)TR
2
= 405.9 USDCompare with TR
1
, we can see that TR
1
> TR
2
. The degree of this difference is:%

TR = (TR
1
TR
2
)/TR
1
= (450 405.9)/450= 0.098 = 9.8%Hence, when price of coffee increases 10%, the
total revenue will decrease 9.8%.
Part B:
In my opinion, the quantity supplied will increase. If the farmers have a goodwheat
crop, it leads an increase in price. Nevertheless, this price is higher than
theequilibrium price and the quantity demanded for wheat will decrease. In the case
of theprice elasticity of demand for wheat is known to be -0.75 mean tha
t
that 1% change inprice cause the quantity demanded to increase 0.75%. Hence,
total revenues will fall, asthe percentage change in quantity demanded will be less
than the percentage change inprice.
References:
Paul G. Keat, Philip K. Y. Young. (2006).
Managerial Economics: Economic Tools for Today's Decision Makers
(5 ed.). Upper Saddle River, New Jersey, 07458, USA:Pearson Education, Inc.