Illustrating with examples, explain the concepts of price elasticity of demand, income elasticity of demand and cross elasticity of demand. Income elasticity of demand measures the responsiveness of demand to a change in income, ceteris paribus. It is the percentage change in demand for a good resulting from a percentage change in income, ceteris paribus. When income changes with other price or non-price factors, such as income, remaining unchanged, income elasticity of demand measures how much to which demand will change, ceteris paribus.
Income elasticity of demand that is negative refers to inferior goods which are of lower quality and are cheaper alternatives. An increase of income will result to a fall in demand of these items. As people’s incomes increase, the demand for such inferior goods will decrease as people now have the ability to purchase goods of higher quality. This will result the demand curve for the inferior goods to shift leftwards. On the other hand, the income elasticity of demand that is positive (between 0 and 1) refers to normal necessity goods. As income increases, basic necessities such as bread, will only rise a little.
The demand for these items rises less than proportionately with a change in income as we have a limited need to consume additional quantities of basic or necessary goods. Therefore, the demand curve will only shift rightwards by a little. Finally, income elasticity of demand that is positive (more than 1) implies to normal luxurious goods. When income increases, the demand for luxury goods such as cars, rises more than proportionately to a change in income as consumers have the confidence and the purchasing power to buy these goods. Hence, the demand curve will shift more significantly to the right.
However, the income level of consumers is another factor which affects the income elasticity of demand. While the income elasticity of demand for basic necessities is less than 1, the income elasticity of demand for necessities is higher for the poor as compared to the rich. Poor people’s (low-income earners) demand for basic necessity will respond differently from rich people to a rise in income. For instance, for a rise in income, the poor may purchase more vegetables than the rich. This is because the rich are already satisfied with the amount of vegetables consumed and are unlikely to buy more vegetables when their income rises.
Furthermore, the same good can be considered as a normal good at low income levels but an inferior good at higher income levels. When income level rises from a low level at first, the demand for a good rises and the good is regarded as a normal good. At low income levels, people buy second hand clothing because the more desirable substitutes, such as branded clothes, are beyond their affordability. When income rises for this group of people, demand for second-hand clothing will decrease as they will buy more branded clothes due to their higher purchasing power.
Cross price elasticity of demand measures the responsiveness of demand for one commodity to a change in the price of another commodity, ceteris paribus. It is the percentage change in the demand resulting from a percentage change in the price of another good, ceteris paribus. When the price of good A changes with other price or non-price factors such as income remaining constant, cross-price elasticity of demand will measure the extent of the change of quantity demanded for good B, ceteris paribus. Cross-price elasticity of demand values can vary from minus infinity to plus infinity.
The absolute size or value of the coefficient shows the degree of substitutability or complementarity. Goods that are close substitutes or close complements will exhibit high (magnitude) of cross-price elasticity of demand. Complements are goods in joint demand. When there is a strong complementary relationship between the two products, the cross-price elasticity will be highly negative. For example games consoles and software games. If the goods are complementary, for example bread and butter then the value of the cross-price elasticity will be negative.
This is because as the price of good A (bread) rises, quantity demanded of bread will fall. Therefore, less of good B (butter) will be demanded. This results in a negative value for cross-price elasticity of good B with respect to good A. On the other hand, with substitute goods such as different brands of cereal, an increase in the price of one good will lead to an increase in quantity demand for the rival product. This results in a positive value for the cross-price elasticity of demand. Also, if the price of good A changes, but there is no change in the quantity demanded for good B, then the goods are said to be independent goods (e. bread and hand phones). In this case, the cross-price elasticity of demand is equal to zero. The two major determinants of cross-price elasticity of demand are the closeness of substitutes or compliments and the degree of differences in prices of the related goods. The closer the relationship between the two goods, the bigger the effect of the change of price of the good on the change of demand for the respective substitute or complimentary good and hence the greater the value of the cross-price elasticity of demand – either positively or negatively respectively.
Two goods, A and B may be substitutes or complements but the cross-price elasticity for good A with respect to good B may not be the same as the cross-price elasticity of good B with respect to good A. This is due to the differences in the prices of the two goods. For example, cars and petrol are consumed together as complementary goods. However, the expenditure on the car forms a greater proportion of total expenditure as compared to the expenditure on petrol.
Hence, if there is a rise in the price of petrol, the demand for cars might fall only marginally as the amount spent on petrol is small compared to the overall cost of owning a car. This means that the cross-price elasticity of demand for cars with respect to the price of petrol is relatively low. However, if the price of cars were to increase instead, there would be a more than proportionate fall in the quantity demanded for cars and there will also be a significant fall in the demand for petrol. Therefore, the cross-price elasticity of petrol with respect to the price of cars is much higher.