Question

5. (6 marks) Suppose an economist estimates that the income elasticity of demand for private car is 2.5. The cross-price elasticity of demand for private cars and Good Z is -1.2. Suppose during an economie recession, household income in general decreases by 20%. How much will the sales volume of private cars change? Show your calculation. (2 marks) How will the sales volume of private cars be affected when the price of Good Z drops by 20%? Explain with calculation. (2 marks) Explain ONE reasonable example for Good Z. (2 marks)

Answer 1

Here,

Income Elasticity of Demand for private cars = 2.5

Now Income Elasticity is given by = %Change in Demand/ % Change in Income

a) % Change in income = - 20%

If 100 is the initial Income , New Income = 80

% Change in volume for Private Cars =Income Elasticity * % Change in Income = 2.5 * (-20/180) = -0.2777%

b)

Cross Elasticity = % Change in Private Cars/ % Change in Z

% Change in Private Cars = -1.2*(-20/180) = 0.1333%

c) Here Since Decrease in the price of Z should increase the demand for Cars

So Z could be Oil