Product Markets: Elasticity of Income and Cross-Price Elasticity
Income Elasticity of Demand
Definition
● A measure of the changing quantity demanded of a good as a response to changes in
buyers’ income
●
%Δ of quantity demanded ÷ %Δ of income
Effects on Demand
● Increased income: increased quantity demanded for normal goods, decreased quantity
demanded for inferior goods
● Decreased income: increased quantity demanded for inferior goods, decreased quantity
demanded for normal goods
Types of Goods
● Normal goods: income elasticity of demand is positive
○ Normal necessities - income inelastic; income elasticity of demand from 0 - 1
○ Luxury goods and services - income elastic; income elasticity of demand is
greater than 1
● Inferior goods/services: income elasticity of demand is negative; goods/services which
exist when superior options are available only if the buyer can afford it
○ Income elasticity of demand is usually strongly positive for inferior luxuries
○ Income of elasticity of demand is usually lower for inferior necessities
Income Effect
● Changes in consumer income impacts the quantity of goods and services demanded
●
Increased income leads to increased demand, decreased income leads to decreased
demand
Uses for Income Elasticity of Demand
● Predictions for the demand of goods/services based on average consumer income
Cross-Price Elasticity of Demand
Youtube Intro to Elasticity of Demand Coefficients (Cross-Price and Income Elasticity)
● http://www.youtube.com/watch?v=QLMJDo9dck0&t=4m55s
Definition
● A measure of the responsiveness of demand for good A caused by a change in the
price of a related good B
● Percentage change in quantity demanded of good A divided by percentage change in
price of good B
●
(% ΔQA) ÷ (% ΔPB)
Effects on demand of types of goods
● With substitute goods, increased price of good A leads to increase in quantity good B
○ ex. increasing the price of Coke increases the demand for Pepsi
○ the cross price elasticity for two substitutes will be positive.
● With complement goods, increased price of good A leads to decrease in quantity good B
○ ex. increasing the price of cereal decreases the demand for milk
○ the cross price elasticity for two complements will be negative
● With unrelated products, increased price of good A leads to no change in quantity good B
○ ex. increasing the price of guitars does not affect the demand for tires
○ the cross price elasticity for two unrelated products will be zero
● The stronger the relationship between two products, the higher is the coefficient of cross-price
elasticity of demand
(complements)
- ← 0 (unrelated products) → + (substitutes)
●
Substitutes - cross price elasticity is
positive for substitutes
●
Complements - cross price elasticity is
negative for complements
Uses for Cross Price Elasticity of Demand
● Estimates of cross-price elasticity are used to predict demand and total revenue
○ ex. Popcorn, soft drinks and cinema tickets have a high negative value for cross
elasticity– they are strong complements. Companies can estimate the effect of a
two-for-one cinema ticket on the demand for popcorn. It is possible to predict
whether or not the promotion leads to enough of an increase in popcorn and
refreshment profit to compensate for lowered entry prices.
Substitution Effect
● Consumers will choose the cheaper alternative when the price of goods rise (or income
decreases)
Brand and Cross-Price Elasticity of Demand:
● when consumers become loyal to a product, the cross price elasticity of demand against
rival products will decrease, reducing the size of the substitution effect following a
price change and makes demand less sensitive to price. Companies can charge a
higher price, increase their total revenue and achieve higher profits.
Multiple Choice
1. If the income elasticity of demand coefficient is negative then the good is
a. a complement
b. a substitute
c. a normal good
d. an inferior good
e. none of the above
2. If the cross-price elasticity of demand coefficient is negative then the good is
a. a complement
b. a substitute
c. a normal good
d. an inferior good
e. none of the above
3. The increase in the demand for widgets, shown in the figure above, is caused by an increase
in the price of McBoover devices from $9 to $11. Therefore, the cross-price elasticity for these
two products is
a. 0.5.
b. -2.0.
c. 2.0.
d. -0.5
4. A fall in the price of X from $12 to $8 causes an increase in the quantity of Y demanded from
900 to 1,100 units. X and Y are
a. complements.
b. normal goods.
c. substitutes.
d. inferior goods.
Free Response
1.
(a) The table below gives the quantity of good X demanded and supplied at various prices.
(i) Is the demand for good X relatively elastic, relatively inelastic, unit elastic, perfectly
elastic, or perfectly inelastic when the price decreases from $30 to $20 ? Explain.
(ii) Is the supply of good X relatively elastic, relatively inelastic, unit elastic, perfectly
elastic, or perfectly inelastic when the price decreases from $30 to $20 ? Explain.
(b) Assume that the income elasticity of demand for good Y is –2. Using a correctly labeled
graph of the market for good Y, show the effect of a significant increase in income on the
equilibrium price of good Y in the short run.
2. Sasha is a utility-maximizing consumer who spends all of her income on peanuts and
bananas, both of which are normal goods.
(a) Assume that the cross-price elasticity of demand between peanuts and bananas is positive.
A widespread disease has destroyed the banana crop. What will happen to the equilibrium price
and quantity of peanuts in the short run? Explain.
(b) Assume that the price of bananas increases. Will the substitution effect increase, decrease,
or have no effect on the quantity of bananas demanded?
Multiple Choice Answers
1. d 2. a
3. c
4. a
Free Response Marking Scheme (Question 1)
a)
- One point is earned for stating that the demand for good X is relatively elastic, because
the elasticity coefficient > 1 OR because total revenue rises as price decreases from $30
to $20.
- One point is earned for stating that supply is perfectly inelastic, because there is no
change in the quantity supplied as the price changes OR because the supply elasticity is
zero.
b)
- One point is earned for a correctly labeled graph of supply and demand.
- One point is earned for showing a leftward shift of the demand curve and a decrease in
the equilibrium price.