TOPIC 3: THE PRICE THEORY

Price Theory is generally concerned with how prices are determined in the market
through the forces of demand and supply. The market is set of arrangement which brings
together buyers and sellers for the purpose of exchanging particular goods and services.

DEMAND THEORY

Individual and market demand

An individual demand for a commodity is the quantity that an individual consumer is
willing and able to purchase at a particular price over a given period of time. The market
demand for a commodity is the sum of quantities demanded by the individual consumers
in the market at a given price level during a given time period. The first two panels of
figure 3.1 represent the demand curves for two consumers.

Figure 3.1 The market Demand Curve

Price
Price Price

15
15
15

10 10
10

D1 DT
D2

0 4 5
0 2 8 0 6 13

Quantity per Period

Quantity per Period Quantity per Period
Individual 1 Individual 2 Total / Market Demand

At a price of $10, the individual quantities demanded are 5 and 8 units, respectively.
Hence the total market demand at the price of $10 (as shown in the third panel) is 13
units. Graphically, the market demand curve is horizontal summation of individual
demand curves.

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Determinants of Market Demand
Among the most important factors that determine market demand include:
a) Price of the product
Increase in price leads to decrease in demand for goods and vice versa ceteris
paribus

b) Consumers’ income
For most goods, an increase in consumer income would cause the demand curve
for the product to shift to the right.

c) Prices of other related products

A rise in the price of a good is likely to lead to increase of demand of its
substitutes. For example, an increase in the price of chicken would cause people
to purchase less of it and consume more beef. An increase in the price of a good
will cause demand for its compliment to decrease. (e.g. fuel and motor vehicle).

Other determinants of demand

d) Consumer Taste and preferences
e) Seasons
f) Government policies such as tax and subsidies
g) Climate
h) Expectations on future prices
i) Changes in population size and composition
h) Advertising

The law (theory) of Demand

This law states that; “there is an inverse relationship between the price of a commodity
and the quantity buyers are willing to purchase in a defined time period, ceteris paribus.”
The higher the price of a commodity the lower is the quantity demanded and vice versa.

Dx = f (Px)

Demand Schedule
Consider the table which shows the demand of product x at different prices.
Consumers demand schedule for product X
Price per Kg in Kshs Quantity demanded per Week.
50 100
40 200
30 300
20 400
10 500

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 Figure 3.2
Demand Curve

Price
of
goods

Quantity
demanded

Demand Function

Demand is a function of its determinants

DX = f (PX,PS, Y, T, Z)

Justification for law of demand

1. Law of diminishing marginal utility –as additional units of a commodity are
consumed, the extra satisfaction (marginal utility) derived from their consumption
keeps on declining and therefore the consumer will be induced to buy more units if
the prices of the additional units are progressively reduced.
2. Income effect – as the prices of goods increase holding consumers income constant
the purchasing power of the money declines allowing them to buy fewer units.
3. Substitution effect – As the price of commodity increases, consumers would give up
some of its units in favor of relatively cheaper substitutes therefore decreasing the
quantities purchased of the commodity.

Movements along and shift of demand curve

Movement along demand curve
It is also known as change in quantity demanded. It is the change in quantity demanded
that is caused by changes in price of a commodity ceteris paribus. There is upward and
downward movement along demand curve. Upward movement is due to increase in price
whereas downward movement is due to decrease in price.

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 Upward movement

Downward movement

Shifts of the demand curve

It is also known as change in demand. It is that change in demand which is caused by
changes in other factors related to demand. An increase in demand shifts the demand
curves the right and vice versa. There are upward and downward shifts of demand.
Upward shift is due to changes in other factors that favour demand whereas downshift is
due to unfavourable changes.

Upward shift

Downward shift

Actual and Statutory Incidence of Tax

Tax authorities usually require either the buyer or the seller to be legally responsible for
payment of the tax. Tax incidence is the way in which the burden of a tax is shared
among the market participants ("who bears the cost?"). Taxes will typically constitute a
greater burden for whichever party has a more inelastic curve – e.g., if supply is inelastic
and demand is elastic, the burden will be greater on the producers.
Suppose that a state government imposes a tax upon milk producers of $1 per gallon.

Figure 3.7: Incidence of Tax

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Figure 3.7 shows the original price for milk was $2 per gallon. After imposition of the
tax, the supply curves shift up and to the left. Consumers pay $2.60 per gallon. Sellers
receive $1.60 per gallon after paying the tax. So sixty cents of the tax is actually paid by
consumers, while forty cents is paid by the milk producers.
The triangle ABC above represents the deadweight loss due to taxation, which occurs
because now there are fewer mutually beneficial exchanges between buyers and sellers.
Deadweight loss stems from foregone economic activity and is a loss that does not lead to
an offsetting gain for other market participants; it is a permanent decrease to consumer
and/or producer surplus.

Exercise
Show the effect of following on the demand curve for good X
1) Decrease in it’s price
2) Fall in consumer’s income
3) Decline in the price of its substitute
4) Consumers expect its price to fall in the near future.
5) Imposition of tax on the good by the government

Interrelated demand
Demand is said to be interrelated if the demand for one commodity affects the demand
for another.
i. Joint demand –demand for complimentary goods.
ii. Competitive demand –demand for substitute goods.
iii. Composite commodities – Demand for those goods serving several purposes
iv. Derived demand – Demand for those goods that are used to produce other goods

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Exceptions to law of demand
Abnormal Demand Curve is a curve which does not conform to the law of demand. This
concept was established by Sir. Robert Giffen hence known as Giffen paradox.
Commodities behaving this way are known as giffen goods. A giffen good is an inferior
good whose demand increases as price increases and demand decreases as price falls.
Giffen goods are inferior goods but not all inferior goods are giffen goods. Some times
we have veblem goods which are prestigious goods whose demand increases as price
increases.

There several situations which bring about abnormality:

1. Giffen goods – type of inferior goods whose demand falls with a fall in price.
2. Veblem goods / Luxury goods – associated with quality and its demand increases as
price increases
3. Speculation or future price expectations –e.g. in the stock market
4. Consumer ignorance / lack of information – Lack of considering all market factors
before making a purchase.
5. Demand for necessities –demand is not affected by the change in prices

Engel curves

These are curves showing the relationship between income and demand. They are
important when distinguishing between normal and inferior goods.

1. Normal goods
As income increases demand increases.

Income

Quantity
demanded

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2. Inferior goods.
As income increases, demand falls.

Quantity
Income demanded

ELASITICITY OF DEMAND
The price elasticity of demand measures the responsiveness of quantity demanded of a
commodity to a change in one of the factors influencing demand. The main measures of
elasticity of demand are:
a) Own price elasticity of demand

b) Income elasticity of demand

c) Cross price elasticity of demand

OWN PRICE ELASITICITY OF DEMAND

The price elasticity of demand measures the responsiveness of quantity demanded of a
commodity to a change in its price. It is the percentage change in quantity demanded
resulting from one percent change in the price of the commodity.
%Q
EP =
%P
For example, if a firm increases the price of its product by 2% and quantity demanded
subsequently decreases by 3%. The price elasticity would be
− 3%
EP = = −1.5
2%
Ep is negative because of the law of demand which states that price and quantity
demanded are inversely related. Thus when the price change is positive, the change in
quantity demanded is negative and vice versa.

Range of Elasticity
The price elasticity of demand of a product must lie between zero and negative infinity. If
the price elasticity is zero, the demand curve is a vertical line; that is quantity demanded
is unaffected by price. If the price elasticity is negative infinity, the demand curve is

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 horizontal line; that is, unlimited amount can be sold at a particular price, but nothing can
be sold if the price is raised even slightly.
The coefficient of elasticity can be classified into three categories:
i) Elastic demand (Ep>1)
A proportionate change in the price of a good gives rise to a more than
proportionate change in quantity demanded. For example a 10% increase in price
causes more than 10% fall in quantity demanded.
ii) Inelastic demand (Ep<1)
A proportionate change in the price of a good gives rise to a less than
proportionate change in quantity demanded. For example a 10% increase in price
causes less than 10% fall in quantity demanded.
iii) Unitary elastic demand (Ep=1)
A proportionate change in the price of a good gives rise to an equal proportionate
change in quantity demanded. For example a 10% increase in price causes a 10%
fall in quantity demanded.

Demand Curves with zero and infinity Price Elasticities

Price Demand Curve,

Price Elasticity = 0

Demand Curve,
15 Price Elasticity = -
 ∞   ∞∞

0
Quantity (Q)

Point and Arc Elasticities

There are two approaches to computing price elasticities. Arc Elasticity is appropriate for
analyzing the impact of discrete (i.e. measurable) changes in price. The point Elasticity
can be used to evaluate the effect of small price changes.

Point Price Elasticity

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The point Elasticity of demand is the elasticity at a given point on the demand curve. It is
given by the following formula.
%Q Q / Q Q P
EP = = = 
%P P / P P Q
Therefore the formula for point price elasticity of demand can be rewritten as
dQ P
EP = 
dP Q

Arc Price Elasticity of Demand

Arc elasticity of demand is elasticity between two points on demand curve.
Arc price elasticity is defined as
Q (P2 + P1 ) / 2 Q2 − Q1 P2 + P1
EP =  = 
P (Q2 + Q1 ) / 2 P2 − P1 Q2 + Q1
Where the subscripts 1 and 2 refer to the original and to the new values, respectively of
price and quantity or vice versa

Determinants of Price Elasticity of Demand

i) Availability of substitutes
Products for which there are close substitutes tend to have higher price elasticities
than products for which there are fewer adequate substitutes. For example the
demand for sugar is more price elastic than the demand for salt because sugar has
better and more substitutes (e.g. honey) than salt. Thus, a given percentage
increase in the price of sugar and salt elicits a larger percentage reduction per time
period in the quantity demanded of sugar than salt.

ii) Proportion of Income Spent

Demand tends to be inelastic for goods and services that account for only a small
proportion of total expenditure. For example a 1-kilogram container of salt will
meet the needs of the typical household for months and costs only a few shillings.
If the price of salt were to double, this change would not have significant impact
on the household purchasing power and hence on its demand for salt.

iii) Time Period

Demand is normally more elastic in the long run than in the short run. Given more
time, the consumer has more opportunities to adjust to changes in prices. For
example in the short run, the price elasticity of demand for fuel may be low
because people have few options. But over a longer period, the price elasticity of
demand for fuel may be much greater than in the short run as people replace their
high fuel consuming vehicles with fuel efficient compact vehicles and to public
transportation and take other steps to reduce fuel consumption.

iv) Habits

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 Commodities whose consumption is habitual tend to have inelastic demands e.g.
cigarettes, beer.

v) Degree of necessity
Goods that form necessities have relatively inelastic demand. e.g. water, food and
clothes.

vi) The number of uses a commodity

A commodity that has more uses has inelastic demand and vice vasa.

THE INCOME ELASTICITY OF DEMAND

When other factors are held constant the income elasticity of a good or service is the
percentage change in demand associated with a 1% change in income. As with price
elasticity, we have point and arc income elasticity.

Point income elasticity

This is given by:
%Q Q / Q
EY = =
%Y Y / Y

Q Y dQ Y
=  = .
Y Q dY Q

Arc Income Elasticity

Q (Y + Y ) / 2 Q − Q Y + Y
EY = Y  (Q22 + Q11 ) / 2 = Y22 − Y11  Q22 + Q11
Where the subscripts 1 and 2 refer to the original and to the new levels of income and
quantity, respectively. Thus arc income elasticity of demand measures the average
relative responsiveness in demand of commodity for a change in income in the range
between Y1 and Y2

Inferior Goods, Necessities and Luxuries

Income elasticities can be either negative or positive. Negative income elasticity implies
that increases in income are associated with decreases in the quantity demanded of goods
and service. Goods that behave this way are called inferior goods. These are inexpensive
goods (e.g. staple food like flour) which consumers consume when they are on a shoe
string budget, but when their income improves they abandon the commodity and switch
to other better commodities (e.g. steak, spaghetti etc).

Normal goods and services have positive income elasticities. Examples of normal goods
include food, clothing, housing, jewelry, education and recreation. Income elasticity is
positive but low (i.e. 0<Ey≤1) for necessities i.e. demand is relatively unaffected by
changes in income. As individuals become wealthier, expenditures on luxuries goods
represent a larger share of their income.

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Income Elasticity and Decision making
Income elasticity for a firm’s product is an important determinant of the firm’s success
during fluctuations in economic activity. During boom periods, when incomes are rising,
firms selling luxury items will find that the demand for their product will increase at a
rate faster than the rate of income growth. However the demand for a luxury item may
decrease rapidly during recession. In the case of necessities, demand is likely to reduce
less rapidly in recession period, while it may increase by less than proportionate increase
in income during boom periods. Knowledge of income elasticity can be useful in
targeting efforts. For example in order to increase sales of luxuries items, a firm should
concentrate its sales efforts on media that reach the wealthier segment of the population.

CROSS-PRICE ELASTICITY OF DEMAND

Cross elasticity of demand is the percentage change in quantity demanded of one good
caused by 1 percent change in the price of some other good. Point cross- price elasticity
of demand is given by:
%Q X Q X / Q X
EX 0 = =
%P0 P0 / P0

Q X P0
= 
P0 Q X
dQ X P0
E XO =
dP0 QX
For large changes in the prices of other goods (Po) arc cross elasticities are appropriate.
The arc cross elasticity is computed as
EP =
Q X

( )
PO2 + P01 / 2 Q X 2 − Q X1 PO2 + P01
= 
( )
P0 Q X 2 + Q X1 / 2 PO2 − P01 QO2 + Q X1
Where the subscripts 1 and 2 refer to the original and to the new levels of income and
quantity, respectively

Substitutes and Compliments

If the value of Exo is positive (i.e. Exo > 0), commodity X and Y are substitutes because an
increase in Po lead to an increase in Qx as X is substituted for Q in consumption. E.g. in
case of coffee and tea, beef and chicken.

When Exo is negative (i.e. Exo < 0), commodity X and Q are complimentary because an
increase in Po leads to a reduction in Qo and Qx e.g. in case of cars and fuel.

Finally if Exo is close to zero the commodities are not related in terms of substitutes or
compliments e.g. beer and pencils.

Cross Elasticity and Decision Making

Firms often use the concept of cross-price elasticity of demand to measure the effect of
changing the price of a product they sell on the demand of other related products that the

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firm also sells. For example, a manufacturer of both razors and razor blades can use the
cross-price elasticity of demand to measure the increase in demand for razor blades that
would result if the firm reduced the price of razors.

Example 1
The demand of a commodity decreases from 2000 to 1500 units when the price changed
from kshs 8 to kshs 10 per unit. Calculate arc price elasticity of demand.

1500 − 2000  10 + 8 
Ep   = −1.29
10 − 8  2000 + 1500 
Example 2
In a certain region the price of beef increased from Kshs 100 to 150 per Kg, leading to a
decrease in quantity demanded of beef from 60 to 40 Kg per month while the quantity
demanded for mutton increased from 200 to 250 Kg, Calculate the cross price elasticity
of demand.
Solution
250 − 200  100 
Ep   = 0.5
150 − 100  200 

Example 3
Mr. Kamau earns kshs 30, 000 per month. His household’s monthly budget shot up by
kshs 2000 after he got a salary increment of 10%. Compute his income elasticity of
demand.

HOME WORK
The monthly demand function for product X in a certain region is expressed as
follows:

QX = 200 – 2PX + 1.2PY + 2.4Y

Where
QX = Sales of Product X, in millions of dollars
PX = price of X in dollars
Y= household disposable income per month.
PY = price of another product in dollars.

Suppose that during a certain period, Px = $40, Y = $ 500, Py = $36

i) Compute point price elasticity of demand for X.

ii) Compute arc cross price elasticity of demand for X and Y between
Py = $36 and Py = $45. State and justify whether the two goods are substitutes or
compliments.

iii) Find the income elasticity of demand for X. State whether the good
is normal or inferior and give a reason.

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Uses of elasticity of demand
Elasticity can be used by the government , consumers and owners of business in the
following ways:

Government
1. Devaluation of currencies
2. Budgeting purposes.
3. Planning purposes in terms of providing public facilities.
4. Imposition of subsidies and taxes.

Business owner
1. Pricing of goods.
2. Type of commodity to trade in the market.
3. Price discrimination.

Consumer
1. Expenditure of income.

THEORY OF SUPPLY

Individual supply
It is the quantities of goods and services which an individual firm or supplier is willing
and able to offer for sale at given price over a given period of time.

Theory or Law of supply

There is a direct (positive) relationship between price and supply of a commodity. As the
price of good increases ceteris paribus, its supply also increases. This is due to profit
maximization since the higher the price the greater the profit margin ceteris paribus.

Individual supply curve

Price

Supply curve

Quantity Supplied

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 Market supply
Refers to summation of all individual supplies in a relevant market

a b c
market su
Price

+ =
+ Quantity
supplied.

Determinants of supply

a) Price of the commodity

b) Other factors related to supply.
1. Price of factors of production
2. Prices of other related goods
3. State of technology
4. Climatic, weather, seasonal condition.
5. Price expectations
6. Objectives of the firm – Can be sale maximization or profit maximization.
7. Government policy such as tax and subsidy
8. Exogenous factors ( natural factors)
9. Transport and communication

Movement along the supply curve

This is change in quantity supplied due to changes in price of commodity ceteris paribus.
It is also referred to as change in quantity supplied. Movement along the supply curve can
be upward or downward. Upward movement implies an increase in quantity supplied due
to an increase in price and price whereas downward movement means a decrease in
quantity supplied due to a fall in price.

Price.

Quantity
15
Shift of Supply curve
This is also known as change in supply. It is the change in supply due to changes in other
factors apart from price of the commodity. An increase in supply shifts the supply curve
to the right while a decrease shifts the supply curve to left.

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 Shift to the right

Price.

Quantity.

Shift to the left

Price.

Quantity.

Interrelated supply
If the supply of a commodity affects the supply of another commodity then that is called
interrelated supply.
a) Joint supply – Refers to supply of those commodities that can be offered together
in the market such that an increase in one of them implies an increase in the other
commodity.
b) Composite supply – refers to supply of substitute goods ‘goods competing for the
same customers’

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 c) Competitive supply – Refers to supply of goods that compete for the same
resources (raw materials).

ELASITICITY OF SUPPLY
The price elasticity of supply measures the responsiveness of quantity supplied of a
commodity to a change in one of the factors influencing demand.

Point Price Elasticity

The point Elasticity of supply is the elasticity at a given point on the supply curve. It is
given by the following formula.
%Q Q / Q Q P
EP = = = 
%P P / P P Q
Therefore the formula for point price elasticity of supply can be rewritten as
dQ P
EP = 
dP Q

Arc Price Elasticity of Supply

Arc elasticity of supply is elasticity between two points on supply curve.
Arc price elasticity is defined as
Q (P2 + P1 ) / 2 Q2 − Q1 P2 + p1
EP =  = 
P (Q2 + Q1 ) / 2 P2 − P1 Q2 + Q1
Where the subscripts 1 and 2 refer to the original and to the new values, respectively of
price and quantity or vice versa

Factors determining the elasticity of supply

1. Time factor
There are three time periods in supply: Monetary period, short run period and long
run period. Monetary period is a time immediately after change in price. Elasticity of
supply is perfectly inelastic because supplies have no time to adjust supply with
change in price. Short run period is case where elasticity of supply is faced with low
inelasticity. At this time only variable factors of production can change with change
in price. Long run period is elastic since there is enough time to change supply with
price.
2. Nature of commodity
Perishable goods have high elasticity of supply.
3. Costs of production
If the cost of production is high its supply tends to be inelastic.
4. Method of production
Efficient production methods increase elasticity of supply.
5. Availability of factors of production
The more readily available the factors of production are, the greater the elasticity of
supply.
6. Government policy
Policies that favour supply of goods increase their elasticity.

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Levels of elasticity of supply
There are five levels of elasticity of supply:

1. Perfectly inelastic supply

In this case elasticity of supply is zero. This implies that price has no effect on
quantity supplied.

Price

Supply
2. Fairly inelastic supply
A very big change in price leads to a very small change in quantity supplied.

Price

30

10
Supply

3. Perfectly elastic supply

Elasticity of supply is infinite meaning at a particular price suppliers can supply
all that the consumers need.

Price

Supply

19
4. Fairly elastic supply
A very small change in price leads to a more than proportionate change in quantity
supplied.

Price

Supply

5. Unit elasticity of supply

In this case elasticity of supply is equal to one. A change in price leads to an equal
proportionate change in quantity supplied. If price change by 10% supply also
changes by 10%.

Price

Supply

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MARKET EQUILBRIUM
Market Equilibrium is a situation where quantity demanded and quantity supplied in a
market are equal.

Price
Supply curve

Equilibrium point

Demand curve

Quantity

In theory if prices exceed the equilibrium level, there will be excess supply and if price
are below equilibrium there will be excess demand.
At equilibrium
Qd = Qs

Example
The following equations represent the demand and supply functions for commodity X.
Find the equilibrium quantity and price.

Qs + 10 = 6p
Qd = -4p + 20

Solution
At equilibrium, Qd = Qs
6p – 10 = -4p + 20
10p = 30
P=3

Q = 6(3) – 10
Q=8

Effects of changes in demand and supply on equilibrium

1. Change in demand.
Increase in demand leads to an increase in price and supply. This means that
equilibrium price increases and equilibrium quantity increases.

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2. Increase in supply
This reduces equilibrium price and increase equilibrium quantity supplied.

Types of Equilibrium
1. Stable equilibrium
This is equilibrium in which any divergence from it will generate a force which will
restore it.
2. Unstable equilibrium.
In this case any divergence from it will generate forces that will push it further away
from the initial equilibrium. This applies for the case of veblem and giffen goods
whose demand curves are upward sloping.

Price mechanism
It is also called the ideal hand or the invisible hand. It is a situation where the natural
forces of demand and supply determine the price. It only operates in a perfectly
competitive environment or condition.

Advantages of Price mechanism

1. Freedom of choice
2. Optimum allocation of resources
3. No wastage because there is no shortage nor surplus
4. There is greater responsiveness to changes in economic environment
5. High quality of output
6. High level of production of output

Demerits of Price mechanism

1. It may lead to unequal distribution of income and wealth

2. It may cause instability or unemployment.
3. Failure to cope with very fast structural changes due to slowness.
4. It doesn’t work during crisis like wars.
5. It can be affected by consumer ignorance.

Due to weaknesses of price mechanism, the government is forced to intervene with the
natural forces of demand and supply. This is done through price legislation control.

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 Price legislation and control
This refers to the fixing of both maximum and minimum price by the government that
sellers or dealers must charge.

Maximum price legislation

This refers to the maximum price possible. It is also know as price ceiling. It is the price
below which sellers can sell but above which they cannot. It’s established to safeguard
consumers from being exploited and its set below equilibrium.

Supply
Price. curve.

Equilibrium
P

Price ceiling.

Demand
Q curve.

Quantity.

Effects of price ceiling

1. There is excess demand
2. Prices increases due to scarcity
3. It leads to hoarding and smuggling
4. It causes long queues
5. It forces the government to employ the anti hoarding and anti smuggling measures

Minimum price legislation

This refers to the minimum price possible set by the government. It is also known as
price floor. In this case sellers can sell above the equilibrium price and its implemented to
encourage supplier to continue supplying.
Supply
Price. curve.

Price floor.
Equilibrium
P

Demand
23 curve.
Q

Quantity
Effects of price floors
a) There is excess supply
b) A decrease in prices
c) Government will be forced to absorb the surplus
d) Government will be forced to look for market

EXERCISE
1. Suppose that the demand functions for tickets for three cinema operators in the
entire market are represented as follows:
First operator: P = 35 – 0.5QA
Second operator: P = 50 – 0.25QB
Third operator: P = 40 – 2.0QC
The market supply equation is given by Qs = 40 + 3.5P
Where P = price in $; Q = quantity of tickets bought/sold
a) Determine the market equilibrium price and quantity of tickets
b) Determine the (market) point price elasticity of demand for tickets at P = $28

2. The following table gives the demand schedules for two related goods.
Commodity X Commodity Y
Price Quantity demanded Price Quantity demanded
150 2000 140 1900
150 1700 160 1650

From the information, calculate the cross elasticity of demand for commodity X
given the price of commodity Y. With a valid reason, identify the nature of the
two goods (3 Marks)
3. In a certain region the price of butter increased from kshs 200 to kshs 250 per
kilogram. As a result the quantity demanded of margarine increased from 1500 to
1600 kilograms. Compute the arc cross price elasticity of demand and interpret it.

4. Suppose that a coffee producing firm estimated the following regression of

demand for its brand of coffee:
QC = 300.0 − 2.0PC + 3.6Y + 4.0Pb − 1.2PS + 2.4 A
Where
QC = Sales of coffee brand C, in dollars per pound

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 Pc = price of coffee brand C in dollars per pound
Y=personal disposable income, in millions of dollars per year.
Pb = price of the competitive brand coffee B, in dollars per pound.
Ps = price of sugar in dollars per pound.
A = advertising expenditure for coffee brand C, in hundreds of thousands of
dollars per year.

Suppose also that this year, Pc = $4, Y = $ 500, Pb = $3.60, Ps = $ 2.0 and A = $ 200
a. Compute point price elasticity of demand for the firm’s brand of coffee C

b. Compute cross price elasticity of demand for the two brands of coffee.

c. Find the income elasticity of coffee if the income doubled. Interpret your answer.

d. Find the advertising elasticity for the coffee if the advertising expenditure was
increased raised by 20%

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