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IAI Actuarial Core Principles · Business Economics · Consumer demand and behaviour

When the price of petrol in India rises by 10%, the quantity demanded of a particular two-wheeler model falls by 6%. Which of the following is the correct interpretation, assuming the two-wheeler and petrol are related goods?

Cross elasticity of demand is -6% divided by 10%, which equals -0.6. The negative sign shows that a higher petrol price reduces demand for the two-wheeler, so the two goods are complements rather than substitutes.

  1. ACross elasticity is +0.6, so the goods are substitutes
  2. BCross elasticity is -0.6, so the goods are complementsCorrect
  3. CCross elasticity is -0.6, so the goods are substitutes
  4. DCross elasticity is +0.6, so the goods are complements
  5. Cross elasticity is -1.67, so the goods are complements

Explanation

Cross elasticity = %change in quantity of the two-wheeler / %change in price of petrol = -6/10 = -0.6. A negative sign means a rise in one price reduces demand for the other, which marks complements. Option 4 inverts the ratio.

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