Consider a demand equation of the form:

where p is price and y is income. Suppose we have estimated the parameters of this equation using market data on prices and quantities, so that α=2, β=0.65, and γ=0.0002. Assume that the initial market price is $10, and that we are interested in examining the welfare effects for a person with income of $50,000.

(a) Compute the baseline demand, price elasticity, and income elasticity for this person. Is the income effect “large” or “small” according to your intuitive understanding?

(b) Consider a price increase to $20. Compute the change in consumer surplus, as well as compensating and equivalent variation for this change. What is the percentage error in this case when we use C rather than CV as our measure of welfare?

Transcribed Image Text:

x=-Bp+ry,