Milk Price Rise and Household Demand in Jaipur
A household in Jaipur has a fixed monthly income of ₹5,000 to spend on milk and pulses. Initially milk costs ₹40 per litre and pulses ₹100 per kg; the household buys 75 litres of milk and 20 kg of pulses, spending exactly ₹5,000. The price of milk then rises to ₹50 per litre while the price of pulses and money income stay unchanged. In the new month the household buys 66 litres of milk and 17 kg of pulses. There are no other goods, no borrowing, and no change in tastes. The household says it has cut milk because everything has become expensive, but its neighbour argues that milk demand is insensitive to price and the fall is only due to lower real income. You are asked to sort out the price and income effects using the data, and to advise a milk cooperative that wants to raise its selling price by 25 per cent without losing revenue.
1. Using the initial values as the base, calculate the price elasticity of demand for milk and classify it. Does the calculation support the neighbour's claim that milk demand is insensitive to price?
Read the worked answer
Percentage change in quantity demanded = (66 − 75) / 75 = −9 / 75 = −0.12, or −12%.
Percentage change in price = (50 − 40) / 40 = 10 / 40 = 0.25, or 25%.
Price elasticity = −12% / 25% = −0.48.
In absolute value this is less than 1, so demand is inelastic in this range, but it is not zero. A 25% price rise reduces quantity by 12%, which is a visible response.
Check total outlay: before, 40 × 75 = ₹3,000; after, 50 × 66 = ₹3,300. Outlay rises when price rises, which is consistent with inelastic demand.
The neighbour is only partly right. Milk may be a necessity with few close substitutes, which makes demand less elastic, but the data do not show insensitivity. Also, the simple percentage method depends on the base; using arc elasticity gives roughly −0.57, still inelastic but not zero. The observed fall combines a substitution effect away from milk and an income effect because real income has fallen.
2. Pulses consumption fell from 20 kg to 17 kg even though the price of pulses did not change. Explain this using income and substitution effects, and state what it implies about the relationship between milk and pulses.
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There is no own-price effect for pulses because their price is unchanged at ₹100 per kg. The fall from 20 kg to 17 kg is therefore not a response to a higher pulses price.
The higher milk price reduces the household's real income: the same ₹5,000 now buys less. If pulses are a normal good, this income effect reduces pulses consumption.
There is also a substitution effect. A higher milk price makes milk relatively more expensive, so the household would normally substitute toward pulses. That substitution effect alone would raise pulses consumption, not lower it.
Since pulses consumption actually falls, the income effect must dominate the substitution effect, or milk and pulses must be complements in household meals so that cutting milk also cuts pulses. The data alone cannot separate the two effects exactly, but they rule out the simple story that higher milk prices automatically push consumers toward pulses.
3. The cooperative is considering a 25 per cent price rise from ₹40 to ₹50 per litre. Using the observed demand response, advise it on revenue. What market conditions could make the observed elasticity unreliable for its decision?
Read the worked answer
At ₹40, revenue = 40 × 75 = ₹3,000. At ₹50, revenue = 50 × 66 = ₹3,300. The price rise increases revenue by ₹300, or 10%, because demand is inelastic in this range. On this evidence, a 25% price rise is revenue-raising.
But the cooperative must not treat −0.48 as a permanent law. The estimate is based on one household and one price change. If the cooperative raises its price alone while rival sellers keep ₹40, its own demand becomes much more elastic because consumers can switch to rivals. If all sellers raise together, the market response is closer to the observed one.
The cooperative should also check whether 66 litres covers its procurement and distribution costs, whether consumers might switch to tea or other drinks over a longer period, and whether the price rise is likely to invite new sellers. A safer strategy is a smaller trial increase with monitoring of rivals' prices and sales, rather than assuming the same elasticity will hold at every price.