Elasticy of Demand

Solution Preview

!.
The coffee shop knows that its elasticity of demand is 0.2. The elasticity of demand referred to here is price elasticity of demand. This is the relationship between price and quantity demanded. It shows the relationship between a change in the quantity demanded of a particular good and a change in its price. It shows price sensitivity. The elasticity of demand shows responsiveness of the quantity demand of a good or service to a change in its price, if other things are kept constant. Elasticity of demand is found by dividing the percent change in quantity demanded by the percent change in the price of a good. Elasticity = percent change in quantity / percent change in price. In case of local coffee shop Increasing the price by 20% means the quantity = 0.2 X 20%, which is equal to 4% decline in quantity. In simple words since the elasticity of the local coffee shop is low, the coffee shop should go in for the increase in the price by 20%. The increase in price by 20% will reduce the quantity sold by 4%. If 100 cups of coffee are sold in a day and the price is increased from $1 to $1.20, the number of cups sold will be 96. So the revenue earned by the coffee shop will be $1.20 X 96 = $115.20. The revenue of the coffee shop will increase from $100 to $115.20. The local coffee shop should increase its price.

2.
If the cigarette manufacturer knows that its elasticity of demand is 1.3, I will not recommend that it should increase its price by 20%. The elasticity of demand is higher than 1 so the demand is elastic and the cigarette maker should not increase its price by 20%. Elasticity = percent change in quantity / percent change in price. In case of cigarette maker Increasing the price by 20% means the quantity = 1.3 X 20%, which is equal to 26% decline in quantity. If 100 cigarettes are sold in a day and the price is ...