In microeconomics, the elasticity of demand refers to the measure of how sensitive the demand for a good is to shifts in other economic variables. In practice, elasticity is particularly important in modeling the potential change in demand due to factors like changes in the good’s price. Despite its importance, it is one of the most misunderstood concepts. To get a better grasp on the elasticity of demand in practice, let’s take a look at a practice problem. Elasticity Practice Problem
This practice problem has three parts: a, b, and c. Let’s read through the prompt and questions. Before trying to tackle this question, you’ll want to refer to the following introductory articles to ensure your understanding of the underlying concepts: A Beginner’s Guide to Elasticity and Using Calculus to Calculate Elasticities. And function for butter in the province of Quebec is Qd = 20000 – 500Px + 25M + 250Py, where Qd is quantity in kilograms purchased per week, P is price per kg in dollars, M is the average annual income of a Quebec consumer in thousands of dollar, and Py is the price of a kg of margarine. Assume that M = 20, Py = \$2, and the weekly supply function is such that the equilibrium price of one kilogram of butter is \$14. a. Calculate the cross-price elasticity of the demand for butter (i.e. in response to changes in the price of margarine) at the equilibrium. What does this number mean? Is the sign important? b. Calculate the income elasticity of demand for butter at the equilibrium. c. Calculate the price elasticity of demand for butter at the equilibrium. What can we say about the demand for butter at this price-point? What significance does this fact hold for suppliers of butter?