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Income Elasticity of Demand • Income elasticity of demand shows what happens to the demand for a particular good as consumers' incomes change? • It measures the rate of response of quantity demand due to a raise (or lowering) in a consumer’s income. • There fore the income elasticity of demand measures the responsiveness of demand to a change in income.
▲Q ----- Q ▲Q Y Ey-------- = ------- . -- ▲y ▲Y Q ----- Y
The degree to which a demand for a good changes with respect to a change in income depends on whether the good is a normal or a luxury or an Inferior good.
Normal Goods • Normal goods are any goods for which demand increases when income increases. • Therefore Income Elasticity of demandis greater than zero (ny >0). All normal goods have positive elasticity of demand.
Inferior Goods • Inferior goods are those when income rises, the quantity demanded actually falls. • In other words an inferior good is a good that decreases in demand when the consumer’s income rises.
Inferior Goods • Thus an increase in income leads to a fall in demand. • Because the inferior goods in question are replaced with ''higher quality'' substitutes. • Therefore income elasticity of demand is lesser than zero (ny<0.) • Inferior goods have negative elasticity of demand. • E.g. clothes from charity shops, cheap bread when your income increase you buy better quality goods
Luxury Good • A luxury good is a good for which demand increases more than proportionally as income rises. • This is because consumers, instead of buying more of only the necessity, will want to use their increased income to buy more of a luxury.
Luxury Good • During a period of increasing income, demand for luxury products tends to increase at a higher rate than the demand for necessities. • Therefore Income Elasticity of demandis greater than one (ny >1). • The 24 Karat Gold jewelry is an example of a luxury good.
Types of Income Elasticity of Demand • The higher the income elasticity, the more sensitive demand for a good is to income changes. • Very high income elasticity suggests that when a consumer's income goes up, consumers will buy a great deal more of that good. • Very low price elasticity implies just the opposite, that changes in a consumer’s income have little influence on demand.
Types of Income Elasticity of Demand • (i) Income elastic • (ii) Income inelastic and • (iii) Negative elastic
(i) Income elastic • For some products, as income rises, demand for the particular good or service rises even faster than income. • The curve moves upward with ever increasing slope. • We say the good or service in question is income elastic.
(i) Income elastic • Many ''luxury'' goods are income elastic; as a person becomes wealthier, he tends to buy more expensive clothing, and jewelry
(ii) Income Inelastic. • As income rises, the quantity demanded also increases, but the increase in quantity demanded increases at a slower rate than the increase in income. • Products of this type are income inelastic.
(ii) Income Inelastic. • The slope of the curve increases, but the rate of increase actually falls. • The curve looks like it will reach some kind of ''maximum'' as income rises.
The slope of the curve indicates that initially, as consumer's incomes rise, demand for these goods also rises. • When the consumer’s income rises after certain level, the goods in demand decreases as income increases further more. • The income elasticity of demand for the products is negative, at certain levels of income.
Applications of Income Elasticity of Demand • In developing countries like India, having scarce resources, income elasticity helps firms to decide what to produce. • Income elasticity of demand also helps a firm to decide its location and to develop its marketing strategies • It also helps the firms to direct their advertisement to the segment of people having high income.
It facilitates in demand forecasting if the rate of increase in income and income elasticity of demand for the products are known. • It helps the firm in production planning in the long run particularly during the different periods of business cycles. • It helps to define the “normal” and “inferior” goods according the income level of the people.
Cross Elasticity of Demand • The quantity of any good that is demanded depends on the prices of its substitutes and its complements also. • Hence it is essential for a manager to know how much demand for one good is affected by changes in the price of another. • This can be measured by the cross elasticity of demand.
Cross Price Elasticity of demand measures the responsiveness of demand for a product to a change in the price of other related products by focusing on the links between changes in the prices of substitutes and complements.
Cross Elasticity of Demand for Complementary Good • A complementary good or complement good in economics is a good which is consumed with another good or together. • Its cross elasticity of demand is negative. Because the price and quantity demanded are inversely related.
For instance, ‘Fuel’ and ‘cars’ are complements. If the price of the fuel increases, the demand for car will decline. Since the price of fuel increases, demand of cars decreases and they move in opposite direction, their cross elasticity will be negative.
Cross Elasticity of Demand for Substitute Good • A good or service is said to be a substitute good for another kind when the two kinds of goods can be consumed or used in place of one another in at least some of their possible uses.
The fact that one good is substitutable for another has immediate economic consequences: insofar as one good can be substituted for another, the demand for the two kinds of good will bound together by the fact that customers can trade off one good for the other if it becomes advantageous to do so. • Thus where the two goods are substitutes the cross elasticity of demand will always be positive.
For example, the two close substitute products: Pepsi and Coke, if the price of Pepsi increases significantly, Pepsi’s customers will switch to Coke which increases the demand for Coke. • The change in the price of Pepsi and demand for Coke are moving in the same direction and hence the cross elasticity is positive.
