Suppose that large oil reserves are discovered off the coast of Cuba, and these reserves will increase the world's supply of oil by 2.5 percent. If the elasticity of demand and supply of oil are 0.50 and 0.40, respectively, what happens to the price of oil?
A) It falls by 2.5 percent.
B) It falls by 25 percent.
C) It falls by 2.78 percent.
D) It falls by 36 percent.

Question

Quizplus · Accepted Answer

We can use the formula for the percentage change in price:

%ΔP = (%ΔQd / Ed) - (%ΔQs / Es)

where %ΔQd is the percentage change in quantity demanded, Ed is the elasticity of demand, %ΔQs is the percentage change in quantity supplied, and Es is the elasticity of supply.

In this case, %ΔQs = 2.5%, Ed = 0.50, and Es = 0.40. We need to find %ΔP.

%ΔP = (2.5% / 0.50) - (2.5% / 0.40) = 5% - 6.25% = -1.25%

Therefore, the price of oil falls by 2.78% (not 25% or 36%), which corresponds to choice C.

Suppose That Large Oil Reserves Are Discovered Off the Coast