# For Classroom Use Only

ANNEXURE

INCOME ELASTICITY OF DEMAND Income elasticity of demand measures the degree of responsiveness of demand for a commodity to a change in consumers’ income. It can be computed by the following

Income elasticity ∴E =

formula:

=

Percentage change in quantity demanded Percentage change in Income [Y =Income level]

∆Q Y . ∆Y Q

Use of Income elasticity: Knowledge of income elasticity of demand for various commodities is useful in determining the effects, of changes income, on business activity on various industries. But the measurement of income elasticity is mostly used in economic analysis than for business analysis. Having forecast of national income, one can apply income elasticity in estimating the likely changes in the demand for one’s product due to changes in income level of the consumers. The sign of income elasticity of demand may be either positive or negative. A positive value for the income elasticity occurs when an increase in income results in an increase in the demand for a good. In this case, the good is said to be a normal good. In practice, most goods seem to be normal goods (and therefore have a positive income elasticity). A good is said to be an inferior good if an increase in income results in a reduction in the quantity of the good demanded. An inspection of the definition of the income elasticity of demand should make it clear that an inferior good will have negative income elasticity. Generic foods, used cars, second hand items, B&W television and similar commodities are likely to be inferior goods for many consumers. Another distinction that is commonly made is between luxuries and necessities. An increasing share of income is spent on luxury goods as income increases. This means a 10% increase in income must be associated with a greater than 10% increase in spending on luxury goods. Using the definition of income elasticity of demand, we can see that a luxury good must have an income elasticity that is greater than one. A smaller share of income is spent on necessities as income rises. This means that necessities have an income elasticity that is less than one. Note that all luxury goods are normal goods while all inferior goods are necessities. (If this is not immediately obvious, note that an income elasticity that is greater than one must necessarily be greater than zero while an income elasticity that is less than zero must be less than one.) Normal goods may be either necessities or luxuries.

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For Classroom Use Only

CROSS ELASTICITY OF DEMAND Cross elasticity of demand measures the degree of responsiveness of demand for good j to a change in the price of good k. It can be computed by the following

Cross elasticity ∴E =

formula:

=

Percentage change in quantity demanded for goods j Percentage change in price of related product k

∆Q Pk . ∆Pk Q

Notice that this cross-price elasticity measure does not have an absolute value sign around it. In fact, the sign of the cross-price elasticity of demand tells us about the nature of the relationship between the goods j and k. A positive cross-price elasticity occurs if an increase in the price of good k is associated with an increase in the demand for good j. This occurs if and only if these two goods are substitutes. A negative cross-price elasticity of demand occurs when an increase in the price of good k is associated with a decline in the demand for good j. This occurs if and only if goods j and k are complements. Use of cross elasticity: The concept of cross elasticity of demand is useful in measuring the interdependence of demand for a commodity and the prices of its related commodities. Its knowledge thus helps a firm to estimate the likely effect on its sales of pricing decisions of its competitors and complementary associates. For example, if the cross elasticity between prepaid service of AKTEL and that of grameenphone is +2, the AKTEL could estimate a 20 percent decrease in the demand for its product with every 10 percent decrease in the price of grameenphone. This concept of cross elasticity is not only useful for competitive market but it also helps to shape up price-output policy of the multi-product firms. For example, Euro Fast Food (EFF), might want to know the cross-price elasticity of demand between it's chicken sandwiches and its beef burger, if it is considering the effect of a 20% decrease in the price of its beef burger. If the cross-price elasticity of demand is 0.5, then a 20% decrease in the price of its beef burger would result in a 10% decrease in the number of chicken sandwiches sold. On the other hand, cross-price elasticity of demand between beef burger and french fries is -0.9, that would indicate a 20% decrease in the price of beef burger would result in an 18% increase in the sale of french fries. This sort of information would be useful in determining what prices to charge and in planning for the impact of such a price change. POINT ELASTICITY AND ARC ELASTICITY Two measures of elasticity are used in calculating price elasticity of demand: Point elasticity, when elasticity is computed at a point on the demand curve it is called point elasticity. If the data is continuous and therefore only marginal changes are calculable by this measure of price elasticity

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For Classroom Use Only

Arc elasticity, when elasticity is calculated over an interval of a demand curve or schedule, the elasticity is called the arc elasticity. If the data is discrete and therefore incremental changes are calculable by this measure of price elasticity.

Example-1: Point and Arc elasticity Px 8 4 0 50 80

A

B

Dx

Point A B

Px 8 4

Dx 50 80

At point A, the price elasticity of demand

While at point B, the said elasticity is:

− 30 / 80 e1 = = −0.375 4/4 e1 = 0.375

is:

30 / 50 = −1.20 −4 / 8 e2 = 1.20 e2 =

Though the two measures of elasticity are different, the both are called point elasticity. In contrast to these, arc elasticity is measured on considering an arc, i.e., a range of curve rather than considering a single point. The calculation of arc

elasticity uses the mid-point values i.e., average value of the two variables under consideration. Thus, the price elasticity of demand on arc AB is: 0.69 (it says that a 1 percent reduction in price brings about a 0.69 percent increase in purchases). Point elasticity Vs. Arc elasticity: Point elasticity measures the elasticity at a particular point on the curve, whereas arc elasticity is the average measurement of elasticity over a segment of the curve. Both the point and arc elasticity are useful. The former is used to find out a change in one variable corresponding to a small change in the other variable while the latter is used to find out a change in one variable resulting from a large change in the other variable. For example, the point elasticity will be more appropriate measure for finding the effect of a price change from Tk. 8 to Tk. 7.75 per unit on demand, while the arc elasticity will be more appropriate measure for estimating similar effect resulting for a price change from Tk. 8 to Tk. 4 per unit on demand.

1 30 / (80 + 50) 30 / 65 2 e= = = −0.69 1 − 4/6 − 4 / ( 4 + 8) 2

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