2.5 Other Elasticities

Unit 2: Supply and Demand

2.5: Other Elasticities

Cross-Price Elasticity

Cross-Price Elasticity of Demand is the measurement of how responsive the market is when a change in the price of one good affects the demand for either a substitute or complementary good.

This type of elasticity helps us answer questions like:

• If the price of Pepsi increases, what will happen to the demand for Coca-Cola, a substitute good for Pepsi?

• If the price of milk decreases, what will happen to the demand for cereal, a complementary good to milk?

Calculating Cross-Price Elasticity of Demand

The formula used in calculating this type of demand elasticity is very similar to price elasticity of demand. The formula and rules are:

Sample Problem: Complements

Sample Problem: Substitutes

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Income Elasticity

Income elasticity of demand is the measurement of how sensitive the market is to a change in consumers' disposable income (money we can spend or save after taxes and other essential expenses). This measure of elasticity shows if a certain good is normal or inferior. A normal good is typically a good we buy when income increases, such as luxury items, new clothes, or fancy meals. An inferior good is a good we typically buy when our income decreases, such as used cars, thrifted clothing, and Ramen.

This type of elasticity helps us answer questions like:

• If consumers' income levels increase, what will happen to the demand for iPhones, a normal good?

• If consumers' income levels decrease, what will happen to the demand for thrift store clothing, an inferior good?

Calculating Income Elasticity of Demand

The formula used in calculating this type of demand elasticity is very similar to price elasticity of demand. When calculating this type of elasticity, we DO NOT drop the negatives. The formula and rules are:

Sample Problems

If a 4% increase in consumer income leads to a 1% increase in the demand for pencils than that means that the income elasticity coefficient is 0.25 (1/4). Since the coefficient is positive it means that pencils are a normal good.

A 4% increase in consumer income leads to a 1% increase in the quantity demanded for pencils. What type of good are pencils?

• Answer

  • Normal good.

• Explanation

  • The income elasticity coefficient is +1% / +4% (remember positive vs. negative matters here!) which equals 0.25. Since the coefficient is positive, pencils are a normal good.

A 12% increase in consumer income leads to a 10% decrease in the quantity demanded for used textbooks. What type of good are used textbooks?

• Answer

  • Inferior good.

• Explanation

• The income elasticity coefficient is -10% / +12% which equals -0.83. Since the coefficient is negative, used textbooks are an inferior good.

  

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Because the coefficient is positive, we identified an iPhone as a normal good. Since normal goods are goods that we typically buy when our income increases, we would demand more iPhones when our income goes up. As shown on the graph ago, the demand curve shifts right.

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Because the coefficient is negative, we determined that the Spam is an inferior good. This means we will buy less of it when our income decreases. This is shown by a leftward shift of the demand curve. Businesses can use the concept of income elasticity to determine under which conditions individuals are more likely or less likely to buy their products.