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Lesson 7. 2 - Income elasticity and Cross elasticity of demand

Income elasticity of demand (Y.E.D) measures how quantity demanded changes with income, classifying goods as normal (positive Y.E.D), inferior (negative Y.E.D), necessity (close to zero), or luxury (greater than 1). Cross elasticity of demand (X.E.D) assesses how quantity demanded of one product changes with the price of another, identifying them as substitutes (positive X.E.D) or complements (negative X.E.D). Understanding these concepts helps analyze consumer behavior in relation to income and pricing changes.

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11 views3 pages

Lesson 7. 2 - Income elasticity and Cross elasticity of demand

Income elasticity of demand (Y.E.D) measures how quantity demanded changes with income, classifying goods as normal (positive Y.E.D), inferior (negative Y.E.D), necessity (close to zero), or luxury (greater than 1). Cross elasticity of demand (X.E.D) assesses how quantity demanded of one product changes with the price of another, identifying them as substitutes (positive X.E.D) or complements (negative X.E.D). Understanding these concepts helps analyze consumer behavior in relation to income and pricing changes.

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19/02/25 Income Elasticity of Demand (Y.E.

D)

• Income elasticity of demand (Y.E.D) is the measure of the responsiveness of the quantity
demanded for a product following a change in income.

Y.E.D = % change in quantity demanded (Q.D)


% change in income (Y)

• Y.E.D is used to classify goods in relation to the changes in consumer incomes.


• In classifying goods, the sign in the value of Y.E.D is important.
(a) If the sign is positive, the good is a normal good.
• Normal goods are goods whose quantity demanded increase as income increases or whose
quantity demanded falls as incomes fall. e.g. cars.
• If an increase in income by 5 % causes an increase in quantity demanded of 5%, Y.E.D = 1
OR if a fall in income by 5 % leads to a fall in quantity demanded by 4%, Y.E.D is 0.8.
• For normal goods, Y.E.D is positive and is expected to be between 0 and 1.
(b) If the sign is negative, the good is an inferior good.
• Inferior goods are goods whose quantity demanded falls with an increase in income or
whose quantity demanded increases with a fall in income.
• There’s an inverse relationship between income (Y) and quantity demanded for inferior
goods.
• e.g. if an increase in income by 10 % causes a fall in quantity demanded by 20 %, Y.E.D is
-2.
• OR a fall in income by 10% leads to an increase in quantity demanded by 20%, Y.E.D is -2.
(c) Necessity goods - a type of normal good whose YED is close to zero.
• With necessity goods, quantity demanded is unlikely to change with a change in incomes.
e.g. foodstuffs such as rice, flour, pulses.
• Necessities have a positive Y.E.D which is close to zero.
• The low value of Y.E.D shows there’s a limit to the quantity bought by consumers, even when
there’s a large change in income.
(d) Superior or luxury goods – a type of normal good with a positive Y.E.D which is greater
than 1.
• For luxury goods, the higher the Y.E.D, the greater the change in quantity demanded.
• Examples of superior goods include designer clothes, jewelry, latest electric devices, or
motorbikes in less developed economies.
The classification of goods in relation to income

Cross Elasticity of Demand (X.E.D)


• Cross elasticity of demand (X.E.D) is a measure of the responsiveness of the quantity
demanded for one product following a change in the price of another product.

X.E.D = % change in quantity demanded of product A


% change in the price of product B

• X.E.D measures how quantity demanded is affected by a change in the price of a related
product.
• X.E.D is elastic when greater than 1, and inelastic when less than 1.
• The sign of the value of X.E.D is important as it classifies whether a product is a complement
or a substitute.
(a) Substitutes - if X.E.D is positive, the two goods are substitutes, and an increase in the
price of one good causes an increase in the quantity demanded of the other good.
• e.g. if a 10% increase in the price of Coca Cola leads to 20% increase in the quantity
demanded for Pepsi, X.E.D is +2. (meaning the goods are substitutes)
(b) Complements - if X.E.D is negative, the products are complements or jointly demanded.
• An increase in the price of one good causes a fall in the quantity demanded of the other
good.
• e.g. if an increase in the price of cars by 10% causes a fall in the quantity demanded of fuel
by 30%, X.E.D is -3. (meaning the goods are complements)
(c) If X.E.D is equal to zero, there’s no relationship between the products.
• e.g. a change in the price of McDonald burgers has no effect on the change in the quantity
demanded for air travel.
Example:
• The average price of computers is $ 1 000, and current sales are 100 units per day. If there’s
a decrease in the price of laptop computers to $ 980, demand for PC’s falls to 96 units per
day. Calculate X.E.D

X.E.D = % change in quantity demanded of product A


% change in the price of product B
= 96 – 100 × 100
100___
980 – 1 000 × 100
1 000

= -4
- -2

=+2

• The positive sign indicates the two products are close substitutes.

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