Income Elasticity of Demand and Cross Elasticity of Demand
In economics, the income elasticity of demand measures the responsiveness of the quantity demanded of a good to the income of the people demanding the good. It is measured as the percentage change in demand that occurs in response to a percentage change in income. For example, if in response to a 10% increase in income, the quantity demanded of a good increased by 20%, the income elasticity of demand would be 2. It is worked out by dividing the % Change in Quantity Demanded by the % Change in Income.
The major determinant of income elasticity of demand is the degree of necessity of the good. In a developed country, the demand for luxury goods expands rapidly as people’s income increases, whereas the demand for basic goods rises only by a little. Thus items such as cars and foreign holidays have a high income elasticity of demand, whereas items such as vegetables and public transport journeys have a low income elasticity of demand.
A negative income elasticity of demand is associated with inferior goods. An increase in income will lead to a fall in the quantity demanded and may lead to changes to more luxurious substitutes. For example, as income rises, people will shift from consuming cheddar to more luxurious and expensive cheese such as Parmigiano-Reggiano.
A positive income elasticity of demand is associated with normal goods. A rise in income will lead to an increase in the quantity demanded. Most luxury goods have a high positive income elasticity of demand. A zero income elasticity of demand means that an increase in income will not lead to a change in the quantity demanded of a good. Many necessities have an income elasticity of demand between zero and one. Expenditure on these goods may increase with income, but not as fast as income does, so the proportion of expenditure on these goods falls as income rises.
Income elasticity of demand is an important concept to firms considering the future size of the market for their product. If the product has a high income elasticity of demand, sales are likely to expand quickly as national income rises, but may also fall significantly if the economy moves into recession.
Cross price elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in the price of another good. It is measured as the percentage change in demand for the first good that occurs in response to a percentage change in price of the second good. For example, if in response to a 10% increase in the price of fuel, the quantity demanded of new cars that are fuel inefficient decreased by 20%, the cross elasticity of demand would be -2. The equation is % Change in Quantity Demanded of Good A divided by the % Change in Price of Good B.
In this example, fuel and cars are complements. This means that one cannot be used without the other. Complementary goods have a negative cross elasticity of demand. On the other hand, where the two goods are substitutes, the cross elasticity of demand is positive, so that as the price of one good rises, the quantity demanded of the substitute good will increase. For example, if the price of coffee rises, people will drink more tea and consume less coffee. When the two goods are perfectly independent, the cross elasticity of demand will be zero. As the price of the first good varies, it will have absolutely no effect on the quantity demanded of the other good.
The main determinant of cross elasticity of demand is the closeness of the substitutes or complements. The closer it is, the bigger will be the effect of a change in the price of the substitute or complement on the first good, and therefore the greater the cross elasticity of demand. Cross elasticity of demand provides vital pieces of information for firms when making their production plans. Firms need to know what effect on the demand for their product will a change in the price of a rival’s product, or of a complementary product, have.