LECTURE NOTES: INCOME ELASTICITY OF DEMAND AND CROSS
ELASTICITY OF DEMAND
Income elasticity of demand measures the relationship between the
consumer’s income and the demand for a certain good. It may be positive or
negative, or even non-responsive for a certain product. The consumer’s
income and a product’s demand are directly linked to each other, dissimilar to
the price-demand equation.
Demand for a normal good grows with an increase in customer wages and vice
versa, assuming other factors of demand are constant. Income elasticity of
demand is the level of response in demand to the adjustment in customer
income.
The larger the income elasticity of demand for a certain product, the greater
the shift in demand there is from a change in consumer income.
Income elasticity of demand denotes the responsiveness to change in
consumers’ income with the change in the demand for a certain good.
For a certain product, the income elasticity of demand can be positive or
negative, or non-responsive.
The larger the income elasticity of demand for a certain product, the greater
the shift in demand there is from a change in consumer income.
Income Elasticity of Demand Measurement
The following formula is used:
Income Elasticity of Demand = % Change in Demand Quantity / %
Change in Income of Consumer
Where:
• % Change in Demand Quantity = Change in Demand Quantity /
Original Demand Quantity
• % Change in Income of Consumer = Change in Income of Consumer /
Original Income of Consumer
Income Elasticity of Demand Types
Based on numerical value, the income elasticity of demand is divided into
three classes as follows:
1. Positive income elasticity of demand
It refers to a condition in which demand for a commodity rises with a rise in
consumer income and declines with a decline in consumer income.
Commodities with positive income elasticity of demand are normal goods.
The upward slope implies that the rise in income contributes to a rise in
demand and vice versa. There are three forms of positive income elasticity of
demand stated as follows:
• Unitary – The positive income elasticity of demand will be unitary if the
proportionate change in the amount of a product demanded equals the
change in consumer income in due proportion.
• More than unitary – The positive income elasticity of demand will be
more than unitary if the proportionate change in the amount of a
product demanded is higher than the change in consumer income in due
proportion.
• Less than unitary – If the change in the amount of a product demanded
in due proportion is less than the change in consumer income in due
proportion, positive income elasticity of demand will be less than
unitary.
2. Negative income elasticity of demand
It refers to a condition in which demand for a commodity decreases with a
rise in consumer income and increases with a fall in consumer income.
Inferior goods are such commodities. For example, the demand for millet will
decrease if the income of consumers increases since they will prefer to
purchase wheat instead of millet. Thus, millet is an inferior good to wheat for
customers.
The downward slope implies that the increase in income contributes to a fall
in demand, and a decrease in income causes a rise in demand.
3. Zero income elasticity of demand
It corresponds to the situation when there is no impact of rising household
income on commodity production. Such goods are termed essential goods. For
example, a high-income consumer and a low-income consumer will need salt
in the same quantity.
Uses of Income Elasticity of Demand
1. Forecasting demand
Forecasting demand applies to the idea that the income elasticity of demand
tends to predict demand for commodities in the future. If there is a substantial
change in wages, the change in demand for products will also be significant.
This is because when buyers become aware of a shift in income, they will
change their preferences and expectations for such products.
2. Investment decisions
The idea of national income is very important to businesses as it helps them to
decide which sectors they should invest their money in. In general, investors
tend to invest in markets where they can predict that the demand for
commodities is related to a growth in national income or where the income
elasticity of demand is greater than negligible.
Cross Elasticity of Demand
The cross-price elasticity formula is an equation for calculating the cross-price
elasticity of demand (XED) of two separate products or services:
Cross price elasticity (XED) = (% change in demand of product A) / (% change
of price of product B),
where products A and B are different offerings.
Cross elasticity of demand refers to an economic concept that usually
measures the responsiveness in the demanded quantity of one good when the
price of another product changes.
Also referred to as the cross-price elasticity of demand, the measurement is
calculated by taking the percentage difference in the demanded quantity of
one good and then diving it by the percentage difference in the price of
another product.
The cross elasticity of demand is an economic concept that measures the
responsiveness in the quantity demanded of one good when the price for
another good changes. Also called cross-price elasticity of demand, this
measurement is calculated by taking the percentage change in the quantity
demanded of one good and dividing it by the percentage change in the price
of the other good.
Cross elasticity on demand also measures the sensitivity of the demand for a
product or service to the variation of the price of a different good or service.
As such, the subject seeks to determine how much the consumption of product
changes when the value and cost of a different product also changes. For
instance, how much increase in the price of vehicles there is when the price of
gasoline declines. Or better yet, how much the decrease in the purchase of
printers there will be if the price of the printer tub goes up.
The cross elasticity of demand can be calculated with any products or
services. Below, you'll learn more about how the relationship between the
products impacts whether they are substitutes, complementariness, or
independent.
How to Calculate Cross Elasticity of Demand
Now that you have the formula for cross price elasticity of demand, it's
important to know how to use it to make your calculations. Here's a step-by-
step run-through of how to do so.
1. Figure out the total quantity demanded of X and the initial price of Y.
2. Determine the final quantity demanded of X and the ending price of Y.
3. For the numerator in the formula above, calculate the percentage
change in the quantity demanded of X. Do this by subtracting the last
and first quantities and dividing that by the total sum of the initial and
final quantities.
4. Now you'll need to calculate the denominator, which is the percentage
change in price. You can do this by dividing the final and initial prices
by the total sum of the last and initial prices.
5. Calculate the cross-price elasticity of demand by dividing the
percentage change in quantity by the percentage change in price.
Understanding Cross Elasticity of Demand
In economics, the cross elasticity of demand refers to how sensitive the
demand for a product is to changes in the price of another product. This
means it determines the relationship between the quantity demanded of one
good when the price for another good or product changes. Put simply, it
measures how demand for one good changes when the price of another
(usually related one) does.
You can use the formula to make comparisons of products that are
considered perfect substitutes for one another or those that are
complementary to one another. For substitute goods, the cross elasticity of
demand remains positive, which means prices increase when demand for one
good rises. Demand for complementary goods drops when the price rises for
another good. This is called negative cross elasticity of demand.
To calculate the cross elasticity, it was evaluated in the following way:
X, Y = Percentage Variation of the quantity demand of X/Percentage variation
of the price of product Y.
In arithmetic terms, the following formula will be used:
Where: Qx = amount of x
Qy = amount of y
Px = price of x
Py = price of y = variation
Substitute Goods
When the cross-elasticity of demand is positive, the product, Y, is substituted
for X. In this case, before experiencing an increase in price Y, the quantity
demand of X will increase. The above illustration implies that consumers can
be a great substitute such that when the price of product Y increases, they
reduce the purchasing power of Y to replace them to a more significant
purchase amount of X.
Example
Let us look at this example closely: butter can substitute margarine. This is at
least for many people. In this instance, if the price of butter goes up, the
amount of margarine demanded is expected to increase as well.
Complementary Goods
When the cross-elasticity is negative, the products, as well as services, are
complementary. This implies that they are consumed together- for instance,
bread and butter. Because most individuals like to consume the products, they
will reduce the purchase of these items thereby reducing the purchase of
bread.
Independent goods
When the cross elasticity is zero, the goods, as well as services, are
interconnected and independent. That implies that buyers don't consider
these goods as substitutes or complements. Therefore, their demands are
independent. Check out this example. Shoes and milk are goods that satisfy
entirely different needs. There's no expected reaction in the industry of shoes
prior to a variation in the milk industry.