Cross Elasticity of Demand

The study of the concept cross elasticity of demand plays a major role in forecasting the effect
of change in the price of a good on the demand of its substitutes and complementary goods.

Therefore, it helps in deciding the price of a good by determining the change in the demand of its
substitutes and complementary goods.

The demand for a good is generally associated with the demand for another good. Therefore,
change in the price of one good produces change in the price of another good. The extent of
relationship between two related goods can be measured by cross- elasticity of demand. In other
words, cross-elasticity of demand measures the receptiveness of quantity demanded of a good
with respect to change in the price of its substitute or complementary good.

Some of the definitions of cross-elasticity of demand are as follows:

In the words of Leibhafsky, “the cross elasticity of demand is a measure of the responsiveness of
T to change in the price of X.”

According to Ferugson, “the cross-elasticity of demand is the proportional change in the quantity
of good-X demanded resulting from a given relative change in the price of the related good-Y.”

It should be noted that the cross-elasticity of demand would be positive, when two goods are
substitute of each other. This is because the increase in the price of one good increases the
demand for the other. On the other hand, in case of complementary goods, the cross-elasticity of
demand would be negative as increase in the price of one good decreases the demand for the
other. For example, increase in the price of tea would result in the increase in the demand for
coffee, whereas increase in the price of petrol would cause decrease in the demand for cars.

Measurement of Cross Elasticity of Demand:

Cross-elasticity of demand expresses the ratio of percentage change in demand of good X

produced due to the percentage change in price of related good Y.

Therefore, the formula for cross-elasticity (ec) of demand is as follows:

ec = Percentage change in quantity demanded of X/Percentage change in price of Y

Percentage change in quantity demanded of X= New demand for X (∆QX)/Original demand for
X (QX)

Percentage change in price of Y= New price for Y (∆PY/Original price for Y (PY)

The symbolic representation of the formula for cross elasticity of demand is as follows:

ec = ∆QX/QX: ∆PY/PY

ec = ∆QX/QX */PY/∆PY

ec = ∆QX/∆PY */PY/QX

∆QX can be calculated by subtracting original demand for X (QX) from increase in demand
(QX1), which is as follows:

∆QX = QX1 – QX

Similarly, PY is the difference between the new price of Y (PY1) and original price for Y (PY).

The Cross Price Elasticity of Demand Formula is

= %∆ in Quantity Demanded of Good x / %∆ in Price of Good y

If XED > o, then the two goods are substitutes. For example: Coke and Pepsi
If XED < o, then they are complements. For example: Bread and Butter
If XED  = 0, then they are unrelated. For example: Bread and Soda

Types of Cross Elasticity of Demand:

The numerical value of cross-elasticity of demand is not same for every related goods. It differs
for different types of goods.

The various types of cross-elasticity of demand are as follows:

i. Positive Cross Elasticity of Demand:

Implies that the cross elasticity of demand would be positive when increase in the price of one
good (X) causes increase in the demand for the other good (Y). In simple terms, cross elasticity
would be positive for substitutes.

In the above figure, quantity demanded for Coke and price of Pepsi are measured along X-axis
and Y-axis respectively. When the price of Pepsi increases from OP to OP1, quantity demanded
for coke rises from OQ to OQ1 and vice versa. Thus, the demand curve DD shows positive cross
elasticity of demand.

For example, the quantity demanded for coffee has increased from 500 units to 550 units with
increase in the price of tea from Rs. 8 to Rs. 10. Calculate the cross elasticity of demand and
state the type of relationship between coffee (X) and tea(Y).

Solution:
QX1 =550 units

QX =500 units

PY1 = Rs. 10

PY = Rs. 8

Therefore, ∆QX = QX1 – QX = 550 – 500 = 50 units

Similarly, ∆PY = PY1 – PY = Rs. 2

Now ec = 50/2*8/500= 0.4

The cross elasticity of “demand is positive; therefore, X and Y are substitutes.

ii. Negative Cross Elasticity of Demand:

Refers to a situation when the rise in the price of one good (X) reduces the demand for the other
good (Y). The cross elasticity of demand would be negative for complementary goods.
In the above figure, quantity demanded for Coke and price of Pepsi are measured along X-axis
and Y-axis respectively. When the price of Pepsi increases from OP to OP1, quantity demanded

for coke rises from OQ to OQ1 and vice versa. Thus, the demand curve DD shows positive cross

elasticity of demand.
For example, the quantity demanded for X decreases from 220 to 200 units with the rise in
prices of Y from Rs. 10 to 12.

Now, the cross elasticity of demand would be as follows:

QX1 =200 units

QX =220 units

PY1 = Rs. 12

PY = Rs. 10

Therefore, ∆QX = QX1 – QX = 200 – 220= – 20 units

Similarly, ∆PY = PY1 – PY = Rs. 12 – Rs. 10 = Rs. 2

Now ec = – 20/2* 12/200= -0.6

The cross elasticity of demand is negative; therefore, X and Y are complementary to each other.

iii. Zero Cross Elasticity of Demand:

Implies that the cross elasticity of demand would be zero when two goods X and Y are not
related to each other. In other words, the increase or decrease in the price of one good (X) would
not affect the demand of other good (Y).
Significance of Cross Elasticity of Demand:

The study of the concept cross elasticity of demand plays a major role in forecasting the effect of
change in the price of a good on the demand of its substitutes and complementary goods.
Therefore, it helps in deciding the price of a good by determining the change in the demand of its
substitutes and complementary goods.

Apart from this, cross elasticity of demand helps in determining the nature of relationship
between two goods whether they are substitutes, complementary to each other or totally different
from each other. In addition, it also enables an organization to anticipate the intensity of
monopoly and extent and type of competition in the market.

Importance of Cross Elasticity of Demand:

The concept of cross elasticity of demand is of great importance in managerial decision making
for formulating proper price strategy. Multi-product firms often use this concept to measure the
effect of change in price of one product on the demand for other products.
For example, Maruti Udyog Ltd. produces Maruti Vans, Alto and Maruti SX-4. These products
are good substitutes of each other and therefore cross elasticity of demand between them is very
high. If Maruti Udyog decides to lower the price of Alto, it will significantly affect the demand
for Maruti Vans and Maruti SX-4. So it will formulate a proper price strategy fixing appropriate
price for its various products.

Further, Gillete Company produces both razors and razor blades which are complements with
high cross elasticity of demand. If it decides to lower the price of razors, it will greatly increase
the demand for razor blades. Thus there is need for adopting a proper price strategy when a firm
produces products with high positive or negative cross price-elasticity of demand.

Second, the concept of cross elasticity of demand is frequently used in defining the boundaries of
an industry and in measuring interrelationship between industries. An industry is defined as a
group of firms producing similar products (that is, products with a high positive cross elasticity
of demand. For example cross elasticity of demand between Maruti SX-4, Hyndui’s Verna,
Tata’s Indigo is positive and quite high. They therefore belong to the same industry (i.e.,
automobiles). It should be noted that because of interrelationship of firms and industries between
which cross price-elasticity of demand is positive and high, any one cannot raise the price of its
product without losing sales to other firms.

Further, the concept of cross elasticity of demand is extremely used in the United States in
deciding cases relating to Antitrust laws and monopolistic practices used by firms. It so happens
that in order to reduce competition that one dominant firm producing a product with high cross
elasticity of demand with the products of other firms tries to take over them and thereby establish
a monopoly, or various firms producing close substitutes with high cross elasticity of demand try
to merge with each other to form a cartel to enjoy monopolistic profits

These actions are held illegal by Antitrust or anti-monopoly laws. An interesting attempt was
made in India by Caca-Cola in 1995 when it returned to India following the adoption of policy of
liberalisation. In order to reduce competition, Coca-Cola Company purchased the firm producing
Thums Up, Gold Spot, Limca which have high positive cross elasticity of demand with Coca-
Cola. Thus, it succeeded in significantly reducing competition. With this its competition has been
mainly with other multinational rival firm Pepsi- Cola.

Numerical Problems on Cross Elasticity of Demand:

1. Suppose the following demand function-for coffee in terms of price of tea is given. Find out
the cross elasticity of demand when price of tea rises from Rs. 50 per 250 grams pack to Rs. 55
per 250 grams pack.

Qc = 100 + 2.5Pt

Where Qc is the quantity demanded of coffee in terms of packs of 250 grams and Pt is the price
of tea.
Solution:
The positive sign of the derivative of Pt shows that rise in price of tea will cause an increase in
quantity demanded of coffee. This implies that tea and coffee are substitutes.

In order to determine cross elasticity of demand between tea and coffee, we first find out
quantity demanded of coffee when price of tea is Rs. 50 per 250 grams. Thus,

Qc= 100 + 2.5 x 50 = 225

Cross elasticity, e. = dQc/dPt x Pt/Qc

dQc/dPt = 2.5

ec =2.5 x 50/225 = 125/225 = 0.51

2. Two goods have a cross-price elasticity of demand of +1.2 (a) Would you describe the goods
as substitutes or complements? (b) If the price of one of the goods rises by 5 per cent, what will
happen to the demand for the other good, holding other factors constant?

Solution:

(a) The goods with positive cross-price elasticity of demand are substitute goods.

(b) If the price of one of the two goods increases by 5 per cent, it will be substituted by the other
good so that the quantity demanded of this other good will rise.
With positive cross-price elasticity being equal to 1.2, the quantity demanded of the other good
will increase by 1.2 x 5 = 6 per cent.

Income Elasticity of Demand

Consumer’s income is one of the important determinants of demand for a product.

The demand for a product and consumer’s income are directly related to each other, unlike price-
demand relationship.

“Income elasticity of demand means the ratio of the percentage change in the quantity demanded
to the percentage in income”-Watson.
For example, the demand for a product increases with increase in consumer s income and vice
versa, while keeping other factors of demand at constant. The degree of responsiveness of
demand with respect to change in consumer s income is called income elasticity of demand.
According to Watson, “Income elasticity of demand means the ratio of the percentage change in
the quantity demanded to the percentage in income.”

Measurement of Income Elasticity of Demand:

The income elasticity of demand (ey) can be measured by the following formula:
ey = Percentage change in quantity demanded/Percentage change in income
Percentage change in quantity demanded = New quantity demanded (∆Q)/Original quantity
demanded (Q)

Percentage change in income = New income (∆Y)/original income (Y)

Therefore, the income elasticity of demand can be symbolically represented as:

ey = ∆Q/Q : ∆Y/Y
ey = ∆Q/Q * Y/∆Y
ey = ∆Q/∆Y * Y/Q
Change in demand (∆Q) is the difference between the new demand (Q1) and original demand
(Q).

It can be calculated by the following formula:

∆Q = Q1 – Q
Similarly, change in income is the difference between the new income (Y1) and original income
(Y).

It can be calculated by the following formula:

∆Y = Y1 – Y

The formula for measuring the income elasticity of demand is same as price elasticity of demand.
The only difference in the formula is that in the income elasticity of demand, income (Y) is
substituted as a determinant of demand in place of price (P). Let us understand the concept of
income elasticity of demand with the help of an example.

Suppose the monthly income of an individual increases from Rs. 6,000 (Y) to Rs. 12,000 (Y1).
Now, his demand for clothes increases from 30 units (Q) to 60 units (Q1).

The income elasticity of demand can be calculated as follows:

ey = ∆Q/∆Y * Y/Q
∆Q = Q1 – Q = 60 – 30 = 30 units

∆Y = Y1 – Y = 12000 – 6000 = Rs. 6000

ey = 30/6000 * 6000/30 = 1 (equal to unity)

Types of Income Elasticity of Demand:
Like price elasticity of demand, the degree of responsiveness of demand with change in
consumer’s income is not always the same. The income elasticity of demand is different for
different products.

On the basis of numerical value, income elasticity of demand is classified into three groups,
which are as follows:
i. Positive Income Elasticity of Demand:
Refers to a situation when the demand for a product increases with increase in consumer’s
income and decreases with decrease in consumer’s income. The income elasticity of demand is
positive for normal goods.

It is explained with the help of Figure

In Figure-12, the slope of the curve is upward from left to right, which indicates that the increase
in income causes increase in demand and vice versa. Therefore, in such a case, the elasticity of
demand is positive.

The positive income elasticity of demand can be of three types, which are discussed as
follows:
a. Unitary Income Elasticity of Demand:
Implies that positive income elasticity of demand would be unitary when the proportionate
change in the quantity demanded is equal to proportionate change in income. For example, if
income increases by 50% and demand also rises by 50%, then the demand would be called as
unitary income elasticity of demand. In such a case, the numerical value of income elasticity of
demand is equal to one (ey = 1)
b. More than Unitary Income Elasticity of Demand:
Implies that positive income elasticity of demand would be more than unitary when the
proportionate change in the quantity demanded is more than proportionate change in income. For
example, if the income increases by 50% and demand rises by 100%. In such a case, the
numerical value of income elasticity of demand would be more than one (ey>1).
c. Less than Unitary Income Elasticity of Demand:
Implies that positive income elasticity of demand would be less than unitary when the
proportionate change in, the quantity demanded is less than proportionate change in income. For
example, if the income increases by 50% and demand increases only by 25%. In such a case, the
numerical value of income elasticity of demand would be less than one (ey<1).
ii. Negative Income Elasticity of Demand:
Refers to a kind of income elasticity of demand in which the demand for a product decreases
with increase in consumer’s income. The income elasticity of demand is negative for inferior
goods, also known as Giffen goods. For example, if the income of a consumer increases, he
would prefer to purchase wheat instead of millet. In such a case, the millet would be inferior to
wheat for the customer.

Figure-13 shows that when income is Rs. 10, then the demand for goods is 4 units. On the other
hand, when the income increases to Rs. 20, then the demand is 2 units. In Figure-13, the slope of
the curve is downward from left to right, which indicates that the increase in income causes
decrease in demand and vice versa. Therefore, in such a case, the elasticity of demand is
negative.

iii. Zero Income Elasticity of Demand:

Refers to the income elasticity of demand whose numerical value is zero. This is because there is
no effect of increase in consumer’s income on the demand of product. The income elasticity of
demand is zero (ey = 0) in case of essential goods. For example, salt is demanded in same
quantity by a high income and a low income individual.
Figure-14 shows the zero income elasticity of demand:

Figure-14 shows that when income increases from Rs. 10 to Rs. 20, then the demand for goods is
remain same, 4 units. In Figure-14, the slope of the curve is parallel to Y-axis (income side),
which indicates that the increase in income causes no effect in demand. Therefore, in such a
case, the elasticity of demand is zero.

Significance of Income Elasticity of Demand:

While price elasticity plays a significant role in pricing of a product to maximize the total
revenue of an organization in the short run, income elasticity of demand is important for
production planning and management in the long run.

Following are some of the important uses of income elasticity of demand:

i. Helping in investment decisions:
Refers to one of the major significance of income elasticity of demand. In developing countries,
such as India, the rate of growth of national income is not steady as it is in case of developed
countries. Moreover in developing countries, rise in national income does not result in immediate
increase in the demand for certain goods.

The concept of national income is very important for sellers as it helps them to allocate their
resources in different industries. Generally, sellers prefer to invest in industries where the
demand for goods is more with respect to proportionate change in the income or where the
income elasticity of demand is greater than zero (ey>1).
For example, the demand for durable goods, such as vehicles, furniture, and electrical appliances,
increases in response to increase in the national income. In such industries, sellers earn high
profits when there is increase in national income. On the other hand, industries with low income
elasticity (ey<1), there is a gradual increase in demand for goods, whereas the demand for goods
having negative income elasticity declines when the national incomes grows.
ii. Forecasting demand:
Refers to the fact that income elasticity of demand help in anticipating the demand for goods in
future. If change in income is certain, there would be a major change in the demand for goods.
This is due to the fact that if consumers are aware of change in income, they may change their
tastes and preferences for certain goods.

On the other hand, if the change in income is temporary, there would be a slow change in the
demand. However, the demand for goods in future is also influenced by various factors other
than income.

iii. Categorizing goods:

Implies that income elasticity of demand helps in classifying goods, such as normal goods,
essential goods, or inferior goods. The classification of goods enables sellers to select the goods
to be produced and the quantity of goods to be produced. Apart from this, it also helps sellers to
decide the income group to whom the goods should target.

Following assumptions are made while classifying goods:

a. A good would be a normal good, if the income elasticity of demand is positive.

b. A good would be an inferior good, if the income elasticity of demand is negative. For
example, millet is inferior to wheat; therefore, the demand for millet is negative.

c. A good would be a luxury good, if income elasticity of demand is positive and greater that one
(ey> 1). For example, the demand for cars and air conditioners is income elastic.
d. A good would be an essential good, if income elasticity of demand is positive but less than one
(ey< 1). For example, food grains and clothes.
e. A good would be neutral, if the income elasticity of demand is zero (ey=0).
How do businesses make use of estimates of income elasticity of demand?

Knowledge of income elasticity of demand helps firms predict the effect of an economic cycle
on sales. Luxury products with high income elasticity see greater sales volatility over the
business cycle than necessities where demand from consumers is less sensitive to changes in the
cycle.

Income elasticity and the pattern of consumer demand

As we become better off, we can afford to increase our spending on different goods and services.
The income elasticity of demand will also affect the pattern of demand over time.

For normal luxury goods - income elasticity of demand exceeds +1, so as incomes rise, the
proportion of a consumer's income spent on that product will go up.
For normal necessities (income elasticity of demand is positive but less than 1) and for inferior
goods (where the income elasticity of demand is negative) – then as income rises, the share or
proportion of their budget on these products will fall
For inferior goods as income rise, demand will decline and so too will the share of income spent
on inferior products.

Importance of Income Elasticity:

The concept of income elasticity is important for decision making both by business firms and
industries. First, the firms producing products which have a high income elasticity have great
potential for growth in an expanding economy.

For example, if for a firm’s product income elasticity of demand is greater than one; it means
that it will gain more than proportionately to the increase in national income. Thus firms which
are producing products having high income elasticity are more interested in forecasting the level
of aggregate economic activity (i.e., level of national income) because the demand for their
products will greatly depend on the level of overall economic activity.

Further, as seen above, the demand for luxuries is highly income elastic. Therefore, the demand
for luxuries fluctuates very much during different phases of business cycles. During boom
periods, demand for luxuries increase very much, and decline sharply during recessionary
periods.

On the other hand, the demand for products with low income elasticity will not be greatly
affected by the fluctuations in aggregate economic activity. During booms the demand for their
products will not increase much and during recessions it will not decrease sharply.

Therefore, the firms with low income elasticity for their products would not be much interested
in forecasting future business activity. Remember it is generally necessities for which demand is
not much income elastic.

However, there is one good thing for the firms which face low income elasticity. They are to a
good extent recession-proof. In the periods of recession, their incomes do not fall to the extent of
decline in aggregate income.

Of course, to share the benefits of increasing national income firms currently producing products
with low income elasticity would try to enter the industries demand for whose products is highly
income elastic as this would ensure better growth opportunities.

The knowledge of income elasticity of demand also plays a significant role in designing market-
ing strategies of the firms. If income of people is an important determinant of demand for a
product, the firms producing product with high income elasticity of demand will be located in
those areas or set up their sales outlets in those cities or regions where incomes are increasing
rapidly.

Besides, the firms will direct their advertising campaigns and other sales production activities to
those segments of people whose income is high and also increasing rapidly. This is to ensure
higher growth of sales of their products.

The concept of income elasticity of demand shows clearly why farmers income do not rise equal
to that of urban people engaged in manufacturing industries. Income elasticity of demand for
agriculture products such as food-grains is less than one.

This implies that it is difficult for the farmers’ income from agriculture to increase in proportion
to the expanding national income. Thus farmers cannot keep up with the urban people who
derive their incomes from industries producing goods with high income elasticity of demand.

What is the formula for calculating income elasticity of demand?

The formula for calculating income elasticity is:

% Change in demand divided by the % change in income

Explain Normal Goods

Normal goods have a positive income elasticity of demand so as consumers' income rises more is
demanded at each price i.e. there is an outward shift of the demand curve

Normal necessities have an income elasticity of demand of between 0 and +1 for example, if

income increases by 10% and the demand for fresh fruit increases by 4% then the income
elasticity is +0.4. Demand is rising less than proportionately to income.

Luxury goods and services have an income elasticity of demand > +1 i.e. demand rises more
than proportionate to a change in income – for example a 8% increase in income might lead to a
10% rise in the demand for new kitchens. The income elasticity of demand in this example is
+1.25.

Explain Inferior Goods

Inferior goods have a negative income elasticity of demand meaning that demand falls as income
rises. Typically inferior goods or services exist where superior goods are available if the
consumer has the money to be able to buy it. Examples include the demand for cigarettes, low-
priced own label foods in supermarkets and the demand for council-owned properties.
The income elasticity of demand is usually strongly positive for

Fine wines and spirits, high quality chocolates and luxury holidays overseas.

Sports cars

Consumer durables - audio visual equipment, smart-phones

Sports and leisure facilities (including gym membership and exclusive sports clubs).

In contrast, income elasticity of demand is lower for

Staple food products such as bread, vegetables and frozen foods.

Mass transport (bus and rail).

Beer and takeaway pizza!

Income elasticity of demand is negative (inferior) for cigarettes and urban bus services.

How do businesses make use of estimates of income elasticity of demand?

Knowledge of income elasticity of demand helps firms predict the effect of an economic cycle
on sales. Luxury products with high income elasticity see greater sales volatility over the
business cycle than necessities where demand from consumers is less sensitive to changes in the
cycle.

Income elasticity and the pattern of consumer demand

As we become better off, we can afford to increase our spending on different goods and services.
The income elasticity of demand will also affect the pattern of demand over time.

For normal luxury goods - income elasticity of demand exceeds +1, so as incomes rise, the
proportion of a consumer's income spent on that product will go up.

For normal necessities (income elasticity of demand is positive but less than 1) and for inferior
goods (where the income elasticity of demand is negative) – then as income rises, the share or
proportion of their budget on these products will fall

For inferior goods as income rise, demand will decline and so too will the share of income spent
on inferior products.