MICRO ECONOMICS

1. If a person decides to buy 20% more bananas because of a 10% income increase. What will be the person's income
elasticity of demand for bananas ?
Solution : The person's income elasticity of demand for bananas is 20% / 10%, or 2.
2. What is the cross price elasticity of demand for Pepsi if the demand for Pepsi decreases by 10% after the price of Coke
decreases by 5%?
Solution: Coke and Pepsi are substitute products. If Pepsi's demand decreases by 10% because Coke's price decreases
by 5%, and assuming no change in the price of Pepsi and no change in other variables in the economy (ceteris
paribus), then the cross price elasticity of demand for Pepsi relative to a price change in Coke is
e cp = (-10%) / (-5%) = +2.
3. What will be the cross price elasticity of demand for computer software if the demand for computer software
increases by 45% because of a decrease of 15% in the price of personal computers?
Solution: The cross price elasticity of demand for computer software relative to a price change in personal computers
is
e cp = (+45) / (-15) = -3.
Note that for cross price elasticity of demand, if the number is negative, the two products are complements. If the
number is positive, the two products are substitutes.
4. If the price of a good increases by 8% and the quantity demanded decreases by 12%, what is the price elasticity of
demand? Is it elastic, inelastic or unitary elastic?
Solutions : -12%/8% = -.12/.08 = -1.5. Again, drop the negative sign, so the elasticity is 1.5. This means it is elastic
(greater than one).
MACRO ECONOMICS
A hypothetical economy's consumption schedule is given in the table below.
GDP = DI C
6600 6680
6800 6840
7000 7000
7200 7160
7400 7320
7600 7480
7800 7640
8000 7800

Use the information to answer the following:

i. If disposable income were Rs.7400, how much would be saved?
ii. What is the "break-even" level of disposable income?
iii. What is this economy's marginal propensity to consume?
iv. What is the average propensity to consume when disposable income is Rs.7000? When disposable income is
Rs.8000.
Answer:
i. Saving is the difference between disposable income and consumption. Since consumption is Rs.7320 when DI is
Rs.7400, saving = Rs.7400 – Rs.7320 = Rs.80.
ii. The break-even level of disposable income occurs where all income is spent and saving is zero. In this example,
the break-even is at Rs.7000.
iii. The marginal propensity to consume is the ratio of the change in consumption to the change in disposable
income. In the table, each change in income is Rs.200 and each change in consumption is Rs.160, so the MPC is
160/200 = .8.
iv. The average propensity to consume is the ratio of consumption to income. At Rs.7000, the APC is 7000/7000 = 1,
while at Rs.8000 it is 7800/8000 = .975.
d.
i. Suppose a Rs.100 increase in desired investment spending ultimately results in a Rs.300 increase in real GDP.
What is the size of the multiplier?
ii. If the MPS is .4, what is the multiplier?
iii. If the MPC is .75, what is the multiplier?
iv. Suppose investment spending initially increases by Rs.50 billion in an economy whose MPC is 2/3. By how much
will this ultimately change real GDP?

Answer:
 i. The multiplier is defined as the ratio of the change in real GDP to the initial change in spending that brought it
about. In this case, the multiplier is Rs.300/Rs.100 = 3.
ii. The multiplier is 1/MPS = 1/.4 = 2.5, in this example.
iii. As the MPS and the MPC sum to one, the multiplier can also be computed as 1/(1 – MPC) = 1/(1 – .75) = 1/.25 =
4.
iv. The multiplier in this example is 1/(1 – 2/3) = 3. The ultimate change in GDP is 3 x Rs.50 = Rs.150 billion.

Problem 1:
Suppose in an economy, autonomous investment (I) is Rs. 600 crores and the following consumption function is given:
C = 200 + 0.8Y
Given the above, find out the equilibrium level of income.
Solution:
The equilibrium level of income is
Y=C+I
C =200 + 0.8Y
I = 600
Putting the values of C and I in the equilibrium (i) we have
Y = 200 + 0.8Y + 600
(Y – 0.8Y) = 200 + 600
Y (1 – 0.8) = 800
Y = 800/0.2 = 800/2/10= Rs. 4000

Problem 2:
Suppose the consumption function of an economy is C = 0.8 Y. Planned investment by entrepreneurs for a year is Rs. 500
crores. Find out what will be the equilibrium level of income.
Solution:
Y= C + I
C = 0.8Y
I = Rs. 500 crores
Substituting the values of C and I in (i) we have
Y = 0.8Y + 500
Y – 0.8Y = 500
Y (1 – 0.8) = 500
0.2 = 500
y = 500 x 10/2 = Rs. 2500 crores.

Problem 3:
Suppose the consumption of an economy is given by
C = 20 + 0.6Y
The following investment function is given:
I = 10 + 02 Y
What will be the equilibrium level of national income?
Solution:
Note that in this problem, investment varies with income. However, this wills not hang our method of determining
equilibrium level of income.
Y=C+I
C = 20 + 0.6Y
I = 10 + 0.2Y
Substituting the values of C and I in (i) we have
Y = 20 + 0.6Y + 10 + 0.2Y
Y = 30 + 0.8Y
Y – 0.8Y = 30
Y (1 – 0.8Y) = 30
0.2Y = 30
Y = 30 x 10/2 = 150
Thus, we find that the equilibrium level of income to be equal to 150.