Income elasticity of demand

This refers to the responsiveness of the quantity demanded of a good or

+ Normal Goods
- Inferior Goods
 Types of Income Elasticity of Demand
• There are five types of income elasticity of demand:
High: A rise in income comes with bigger increases in the quantity
demanded.
Unitary: The rise in income is proportionate to the increase in the quantity
demanded.
Low: A jump in income is less than proportionate to the increase in the
quantity demanded.
Zero: The quantity bought/demanded is the same even if income changes
Negative: An increase in income comes with a decrease in the quantity
demanded.
• For example, let's assume that you've been working hard for the past
year, and as a result, your income has increased from $50,000 to
$75,000 in a year. When your income has increased, you increase the
number of clothes you buy in a year from 30 units to 60 units. What is
your income elasticity of demand when it comes to clothes?
 Cross-price elasticity of demand
The responsiveness of the quantity demanded of one good or service to
changes in the price of another good or service.
If the quantity demanded of one good increases significantly when the
price of another good increases, the two goods are said to be substitutes.
If the quantity demanded of one good decreases significantly when the
price of another good increases, the two goods are said to be
complements.

+ substitutes
- Complements
• Demand for torches was 10,000 when the price of batteries was $10,
and the demand rose to 15,000 when the price of batteries was
reduced to $8.
Solution:-
• Percentage change in the number of torches
= [(15000 – 10000) / (15000 + 10000)] / 2 = 5000 / 12500 = 40%
• Percentage change in price of batteries
= [(8 – 10) / (10 + 8)] / 2 = -2 / 9 = -22.22%
• Thus, cross-price elasticity of demand = 40%/-22.22% = -1.8
• Since the cross-price elasticity of demand for torches and batteries is
negative, thus these two are complementary goods.
 Advertising elasticity of demand
This refers to the responsiveness of the quantity demanded of a good
or service to changes in advertising expenditures. If the quantity
demanded increases significantly in response to an increase in
advertising, demand is said to be advertising elastic. If the quantity
demanded changes only slightly in response to changes in advertising,
demand is said to be advertising inelastic.
 Notes on: Use of Price Elasticity
• Knowledge of price elasticity of demand for a commodity is very useful for its
producers, and others dealing with that, in support of business decision-
making. If the manager were aware of the elasticity for his/her commodity,
he/she would know whether a change in price would be worthwhile or not in
respect of demand, revenue and profit. Knowledge of price elasticity of
demand will also guide the Firm to ascertain whether its sales proceeds
would increase, decrease or remain constant in the face of price variations.
This, in turn, would help a businessman to decide whether he/she should cut
or raise his/her price of the goods in question in a particular case.
• In general, for items with elastic demand, decision comes to relatively low
variation in prices, while items with inelastic demand, decision may come to
higher variation in price considering other conditions. Furthermore, the
knowledge of price elasticity of demand would enable the Firm to estimate
the likely demand for its product at different prices.
 Factors that Affect Elasticity
1. Availability of Substitutes: If there are many substitutes for a product, then
it is likely to have an elastic demand because consumers can easily switch to a
substitute if the price of the product increases.
2. Nature or type of Good : The Elasticity of Demand for a good is affected by
its nature. Different goods can be a necessity good, a comfort good, or a
luxury good for a person.
i. A necessity good like vegetables, food grains, medicines and drugs, has
an inelastic demand. Such goods are required for human survival so their
demand does not fluctuate much against a change in their price.
ii. A comfort good like a fan, refrigerator, washing machine, etc., has an elastic
demand as their consumption can be postponed for a time period.
iii. A luxury good like AC, Cars, Diamond has a relatively high elasticity of
demand when compared to comfort goods.
 Factors that Affect Elasticity cont….
3. The proportion of income spent on the good: The price elasticity of
demand tends to be low when spending on a good is a small
proportion of their available income. Therefore, a change in the price of
a good exerts a very little impact on the consumer’s propensity to
consume the good. Whereas, when a good represents a large chunk of
the consumer’s income, the consumer is said to possess a more elastic
demand.
4. Time elapsed since a change in price: In the long term, consumers
are more elastic over longer periods, as over the long term after a price
increase of a good, they will find acceptable and less costly substitutes.
 Summary
• Price elasticity of demand measures how much the quantity demanded
responds to changes in the price.
• Price elasticity of demand is calculated as the percentage change in
quantity demanded divided by the percentage change in price.
• If a demand curve is elastic, total revenue falls when the price rises.
• If it is inelastic, total revenue rises as the price rises.
 Summary
• The income elasticity of demand measures how much the quantity
demanded responds to changes in consumers’ income.
• The cross-price elasticity of demand measures how much the quantity
demanded of one good responds to the price of another good.
• The price elasticity of supply measures how much the quantity supplied
responds to changes in the price. .
 Summary
• In most markets, supply is more elastic in the long run than in the
short run.
• The price elasticity of supply is calculated as the percentage change in
quantity supplied divided by the percentage change in price.
• The tools of supply and demand can be applied in many different
types of markets.