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BRIAN ROPI INCOME AND CROSS ELASTICITY OF DEMAND LOWER SIX

Income Elasticity of Demand (YED or Ey)

Income elasticity of demand (YED) is the relationship between the percentage changes in
quantity demanded of a good due to a percentage change in income. YED measures the
degree of responsiveness of the quantity demanded of good to changes in income.

It is expressed as:

For most goods, income and quantity demanded will move in the same direction meaning an
increase in income will lead to an increase in quantity demanded and vice versa. These goods
are called normal goods for example luxurious goods such as jewellery – YED is positive.

For some goods, income and quantity demanded will move in opposite directions. An
increase in income will lead to a decrease in quantity demanded and vice versa. YED is
negative. These goods are called inferior goods e.g. public transport, second hand clothing,
cheap food stuffs etc.

When quantity demanded does not change as income changes YED = 0. This is true for
necessities like mealie meal.

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BRIAN ROPI INCOME AND CROSS ELASTICITY OF DEMAND LOWER SIX

Types of income elasticity of demand

Change in Income
Change in Quantity Type of
Ratio Elasticity of
Income Product
Demanded
Demand

A +10 +15 +1.5 Normal Positive

B +10 +10 +1.0 Normal Unity/ Unitary

C +10 +5 0 +0.5 0 Normal Positive

D +10 -5 - 0.5 Zero

E +10 Inferior Negative

A. Here the product is normal with the percentage increase in the quantity demanded
outweighing the percentage rise in income, so that a 10% rise in income results in a
15% increase in quantity demanded, giving a YED of +1.5. This would suggest that
the product could be a consumer durable such as a CD player where the demand
increases rapidly as income increases.

B. Here the 10% rise in income leads to exactly the same 10% increase in quantity
demanded, giving a YED of +1.

C. Here the percentage increase in the quantity demanded is smaller than the percentage
rise in income, so that a 10% rise in income results in a 5% increase in quantity
demanded, giving a YED of +0.5. Basic foodstuffs is a type of product which could
result in this response since we would not expect a substantial increase in the quantity
of basic food purchased as income rises.

D. Here the 10% rise in income has no effect on the quantity demanded, giving a zero
income elasticity of demand.

E. Here the 10% rise in income leads to a 5% decrease in the quantity demanded, giving
a YED of −0.5. Clearly this is an inferior product or inferior good, with consumers
switching away from this product to a better quality alternative which they can now
afford.

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BRIAN ROPI INCOME AND CROSS ELASTICITY OF DEMAND LOWER SIX

The relationship between the quantity demanded of a product and income can be understood
further by studying the diagram below

Income Elasticity of Demand

Quantity
Demanded

Normal Good Zero Income Inferior Good

+ve Income Elasticity - ve Income
Elasticity of Demand Elasticity of Demand

Y1 Y2
Income

The figure illustrates three situations relating to income elasticity of demand. Up to an

income level Y1 the quantity demanded of the product increases as income rises, indicating a
positive income elasticity of demand and thus a normal good. As income rises between Y1
and Y2 the quantity demanded of the product remains unchanged; the income elasticity of
demand is thus zero. Finally, as income rises above Y2 the quantity demanded decreases,
thus illustrating negative income elasticity of demand and an inferior good.

Factors Affecting YED

1. Current standard of living

2. Type of good (normal, inferior)

3. Level of consumer‘s income

Cross Elasticity of Demand (XED/CED)

XED measures the degree of responsiveness of the quantity demanded of one good (A) to
changes in the price of another (B). This can be rewritten as:

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BRIAN ROPI INCOME AND CROSS ELASTICITY OF DEMAND LOWER SIX

This can be written as:

Where:

𝑸𝑨 = the original quantity of product A

𝑷𝑩 = the original price of product B

∆𝑸𝑨 = the change in the quantity of product A

∆𝑷𝑩 = the change in the price of product B

Three possible outcomes are shown in the diagram below, with the sign of XED telling us
something about the relationship between the two products. The size (or magnitude) of XED
tells us how close the two products are, whether as substitutes or complements in
consumption

Cross Elasticities of Demand

Price of
Good B (3)

(1)

(2)

Quantity Demanded
of Good B

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BRIAN ROPI INCOME AND CROSS ELASTICITY OF DEMAND LOWER SIX

Line (1) illustrates a positive cross elasticity of demand with respect to a substitute in that as
the price of product B rises the demand for product A increases.

Line (2) illustrates a negative cross elasticity of demand with respect to a complement, in that
as the price of product B rises the demand for product A decreases.

Line (3) illustrates a situation where the cross elasticity of demand is zero, in that as the price
of product B rises there is no effect on the demand for product A.

Substitute Goods

The cross elasticity of demand for substitute goods is always positive because the demand for
one good increases when the price for the substitute good increases. For example, if the price
of coffee increases, the quantity demanded for tea (a substitute) increases as consumers
switch to a less expensive yet substitutable alternative. This is reflected in the cross elasticity
of demand formula, as both the numerator (percentage change in the demand of tea) and
denominator (the price of coffee) show positive increases.

Items with a coefficient of 0 are unrelated items and are goods independent of each other.
Items may be weak substitutes, in which the two products have a positive but low cross
elasticity of demand. This is often the case for different product substitutes, such as mince
versus soya chunks. Items that are strong substitutes have a higher cross-elasticity of demand.
Consider different brands of tea; a price increase in one company’s green tea has a higher
impact on another company’s green tea demand.

Complementary goods

Alternatively, the cross elasticity of demand for complementary goods is negative. As the
price for one item increases, an item closely associated with that item and necessary for its
consumption decreases because the demand for the main good has also dropped.
For example, if the price of cars increases, the quantity demanded for fuel
drops as consumers are buying less cars and need to purchase less fuel. In the
formula, the numerator (quantity demanded of fuel) is negative and the denominator (the
price of cars) is positive. This results in a negative cross elasticity.

Practical Applications of the concepts of elasticity

Producers would be interested in the concepts of elasticity because their price policy will be
affected by the response expected. For price elasticity of demand, the producer will push up

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BRIAN ROPI INCOME AND CROSS ELASTICITY OF DEMAND LOWER SIX

prices if the demand for the product is inelastic (in the case of necessities or goods with no
close substitutes). If demand for the product is elastic, then the producer will lower price in
order to maximize sales and revenue. This is the case of luxuries or goods with several
substitutes.

The concept of elasticity of demand is also useful to a monopolist to practice price

discrimination.

For income elasticity of demand, the producer must first consider whether the production is
a normal good or an inferior good. If it is a normal good, then he will promote the good when
there is an increase in income example being bonus time. Promotions can be in the form of
some marketing gimmicks such as “buy one get one free”, or lucky draws or “buy one and
get the second one at a lower price”. The producer can also promote the good with attractive
display or perhaps demonstrations.

However, if the product is an inferior good, the producer would only promote the good in
times of falling income or when the economy is in a state or recession. For example, the
supermarket manager can promote instant noodles and canned food. In the case of an inferior
good, a falling income will lead to an increase in quantity demand.

For cross elasticity of demand where the two products are substitutes, with an increase in
the price of one good (e.g. chicken) the producer will promote the substitutes (e.g. pock,
mutton, fish, beef). This will increase sales and hence more revenue.

For negative cross elasticity of demand, the producer will promote complements. For
example, if the price of bread has fallen, the producer will promote spreads such as butter,
honey, peanut butter and jam. This will also boost sales.

There are also other uses of the concept of elasticity other than increasing sales. For example,
elasticity concepts will be useful to determine tax burden and to identify the market structures
that the business is in.

1. Important in Factor Pricing: The concept of elasticity of demand is useful in

determination of factor prices. The factor of production for which demand is
relatively inelastic can command a higher price as compared to those having elastic
demand. For example, workers can ask for higher wages, if the demand for the
product produced by them is relatively inelastic.

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BRIAN ROPI INCOME AND CROSS ELASTICITY OF DEMAND LOWER SIX

2. Importance to Government: Taxation policy of the Government is based on

the concept of elasticity of demand. Those commodities whose demand is relatively
inelastic will be taxed more because it will not affect their demand much and vice-
versa.

3. Decisions on Public Utilities: In case of public utilities like transport, water

and electricity which have an inelastic demand, Government can either subsidise or
nationalise them to avoid consumer’s exploitation.

4. Importance in Foreign Trade: The concept of elasticity of demand is useful to

determine terms and conditions in foreign trade. The countries exporting commodities
for which demand is relatively inelastic can raise their prices. For example,
Organization of Petroleum Exporting Countries (OPEC) have increased the price of
oil several times. The concept is also useful in formulating export and import policy
of a country.

NOTE - Take note of the following terms:-

a. Joint demand/ Complementary demand that is. demand for complements

b. Competitive demand that is. demand for substitutes

c. Composite demand - A good is said to be in composite demand if it is

demanded for several uses/different uses e.g. wool would be demanded by the textile
industry, blanket manufacturers etc. The demand for such goods are the aggregates of
the demands of the various users.

d. Joint supply – this means the production of one good automatically leads to
the output of another

e.g. peanut butter and oil, beef and hides, mutton and wool, lead and zinc.

<BH>Practical Limitations of the concept of elasticity

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BRIAN ROPI INCOME AND CROSS ELASTICITY OF DEMAND LOWER SIX

In theory, the various measures of the elasticity of demand help managers to understand the
impact of changes in different variables on their sales. This is important to their planning for
example when estimating the required staffing and stock levels. However, whilst a
knowledge of the price, income and cross elasticities of demand would certainly be useful, in
reality using them can be difficult due to the following reasons:

a. They do not show the actual cause and effect. For example, an increase in
demand may be accompanied by an increase in income. It could be that the higher
advertising has caused the increase in demand. However, it could be that with more
demand marketing managers feel they have the funds necessary to pay for more
advertising. The initial increase in demand may have been caused by something
entirely. It is not necessarily the increase in advertising that is causing the increase in
demand and so a high advertising elasticity of demand may be misleading in terms of
future decision making.

b. Each of the equations for the elasticity of demand measures the relationship
between one specific factor and demand, for example the price elasticity of demand
analyses the impact of a change in price on the quantity demanded. In reality many
factors may be changing at the same time such as the spending on advertising,
competitors’ promotional strategies and consumers’ incomes, as well as the firm’s
price. It may therefore be difficult to know what specifically caused any changes in
the quantity demanded. Any change in the quantity demanded may not have been due
to a price change at all, and so the value of the price elasticity of demand may be
misleading.

To know the elasticity of demand managers must either look back at what happened in the
past when, for example, prices or income were changes (but the conditions are likely to have
altered since then) or estimate for themselves what the values are now (in which case they
may be wrong because it is an estimate). The value of elasticity is, therefore, not actually
known at any moment, it is merely estimated. This means that managers should be careful
about basing their decisions on their estimates of the elasticity as the value will be changing
at the time as demand conditions change.

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