Question

Suppose that the price elasticity of demand for cereal is -0.75 and the crossprice elasticity of demand between cereal and the price of milk is -0.9. If the price of milk rises by 10%, what would have to happen to the price of cereal to exactly offset the rise in the price of milk and leave the quantity of cereal demanded unchanged?

Answer 1

Answer: Price of cereals must fall by 12%

Explanation:

A 10% rise in the price of milk will lead to a fall in quantity demanded by =-0.9 * 10= 9%.  

To prevent the demand for cereals from falling by 9%, the price of cereals must fall by

$E = \frac{Percentage change in Qd}{Percentage change in price}$

$Percentage change in price = \frac{Percentage change in Qd}{e}$

$Percentage change in price = \frac{9}{-0.75}$

$Percentage change in price = -12%$

Thus, to offset the effect of a 10% rise in price of milk, the price of cereals must fall by 12%.