Rice Price Rise at a Neighbourhood Store
Kavitha runs a neighbourhood cooperative store in Vijayawada that sells rice and pulses. In January, rice is priced at ₹50 per kg and pulses at ₹100 per kg. A representative household with a fixed monthly income of ₹40,000 buys 40 kg of rice and 20 kg of pulses. In February the store raises the rice price to ₹60 per kg; pulses and household income are unchanged. The same household now buys 32 kg of rice and 22 kg of pulses. The store's owner argues that since rice is a staple, demand must be inelastic and a higher price should raise rice revenue. She also plans a further increase to ₹65, expecting the same pattern. The store has no competitors within walking distance, but households can buy rice from a bus-stand market about two kilometres away. The owner asks you, as a student of economics, to interpret the household's response and advise on the pricing plan.
1. Using the midpoint (arc) formula, estimate the household's price elasticity of demand for rice between ₹50 and ₹60. On that basis, examine whether the owner's claim that demand is inelastic is supported.
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Midpoint formula: e = (ΔQ / average Q) ÷ (ΔP / average P).
- ΔQ = 32 − 40 = −8 kg; average Q = (40 + 32)/2 = 36 kg.
- ΔP = 60 − 50 = ₹10; average P = (50 + 60)/2 = ₹55.
- e = (−8/36) ÷ (10/55) = −0.2222 ÷ 0.1818 ≈ −1.22.
Demand is elastic over this range (|e| > 1), not inelastic. Rice revenue falls from 40 × ₹50 = ₹2,000 to 32 × ₹60 = ₹1,920, so the price rise reduces revenue. The owner's inference from 'staple' to 'inelastic' is not valid: a staple can have elastic demand when close substitutes are available (the bus-stand market two kilometres away) and when rice takes a large share of the budget. Caveat: this is one household, and other factors may have changed; but the observed response contradicts the claim. A further rise to ₹65 is likely to reduce revenue further unless the household has no alternative.
2. The household buys more pulses after the rice price rises. What does this indicate about the relationship between the goods, and how should the store use that information in pricing and stocking decisions? Distinguish substitution from income effects.
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Cross-price elasticity = (ΔQ_pulses / average Q_pulses) ÷ (ΔP_rice / average P_rice) = (2/21) ÷ (10/55) ≈ 0.0952/0.1818 ≈ +0.52. Positive cross elasticity indicates substitutes: as rice becomes relatively more expensive, the household shifts toward pulses. This is mainly a substitution effect. There is also an income effect: the higher rice price reduces the household's real purchasing power; if both goods are normal, that would push both quantities down. Pulses rise, so substitution outweighs any normal-income effect. The store should not read this as proof that rice is inferior. Practical response: keep pulses well stocked and consider a small bundle or loyalty offer linking rice and pulses; do not assume rice demand is captive. Because the response is based on one household, the store should track a larger sample before changing all prices.
3. Can the data show that rice is a Giffen good or an inferior good for this household? Explain what additional evidence you would need and why the February observation alone is not decisive.
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No. A Giffen good must show a positive relationship between own price and quantity demanded: when price rises, quantity demanded rises. Here quantity falls from 40 kg to 32 kg, so rice behaves as an ordinary good in this observation. Inferiority is also not established: 'inferior' refers to income elasticity, and household income was held constant at ₹40,000. The fall in rice could be entirely a substitution effect plus a small income effect. To test inferiority, you would need data on quantities at different income levels with prices constant, or estimate income elasticity. To test Giffen behaviour, you would need a sustained price rise with no change in substitutes and evidence that the negative income effect dominates substitution. One price change for one household is not decisive; the nearby market also gives a substitute, which weakens the Giffen possibility.