CHAPTER 7 INCOME & CROSS ELASTICITIES OF DEMAND
(H2 Economics Only)
Previously, we cover the concepts of the price elasticity of DD and of SS. Now, we move onto income & cross elasticities of demand. Think of such concepts as an extension to the basic demand factor of income, and of related goods and services. For related products, do make sure to clearly highlight if you mean substitutes in demand, or substitutes in supply, and so on.
Elasticity of demand for a good measures the responsiveness of quantity demanded to a change in one of its determinants. In this chapter, we focus only two 2 determinants of income and related products. We focus on the price factor, the non-price factor of incomes and prices of related goods. This is only for H2 Economics pupils, you have 2 more elasticity concepts to apply in your tests of Econs essays and case study papers.
7.1 Definition of Income Elasticity of Demand (YED)
Income elasticity of demand (YED) is defined as the degree of responsiveness of demand to a change in the income of consumer, ceteris paribus.
It is measured by dividing the percentage change in quantity demanded of the good by the percentage change in income holding everything else constant. Income elasticity of demand can be positive and negative.
7.1.1 Positive income elasticity (YED>0)
Goods with positive YED are normal goods. Demand moves in the same direction of income. When income increases, demand for these goods rises. Conversely, when income falls, quantity demanded for these goods fall. E.g.: ocean cruises, shoes and computers.
7.1.2 Negative income elasticity (YED<0)
Goods with negative YED are called inferior goods. Demand moves in opposite direction of income. Consumption of such goods decreases in response to an increase in income. Conversely, consumption of these goods increases with a fall in income. E.g.: canteen food compared to restaurant food and poor quality soap compared to shower foam, in-house bread of Giant supermarket vs. Boujour bread.
7.2 Interpretation of YED Values
7.2 Interpretation of YED Values
In the range of normal goods, it can be further split into two ranges.
Income elastic (YED>1)
If the demand for a good is income elastic a 1% change in income leads to a more than proportionate change in the quantity demanded. I.e. luxury goods such as ocean cruises, custom clothing, international travel, jewellery and works of art.
Income inelastic (0<YED<1)
If the demand for a good is income inelastic a 1% change in income leads to a less than proportionate change in the quantity demanded. i.e. necessities such as food, newspapers, magazines and clothing.
Zero Income elasticity (YED=0)
If the quantity purchased remains unchanged when income increases. Examples will be chilli and salt.
7.3 Determinants of YED
Income is very straight-forward, and there are few YED determinants only.
7.3.1 Degree Of ‘Necessity’ Of The Good
The more basic a good is the lower will be the income elasticity. In developed countries, the demand for luxury goods expand rapidly as people’s income rises, whereas the demand for basic good, such as bread, only rises a little. Thus, items such as cars and foreign holidays have a high income elasticity of demand, whereas items such as potatoes and bus journeys have a low income elasticity of demand.
7.3.2 The Rate At Which The Desire Of A Good Is Satisfied As Consumption Increases
The more quickly people becomes satisfied, the less their demand will expand as income increases, for example, food. One need not consume too much food before feeling satisfied. In Singapore, where most people have more than enough to eat, an increase in income will lead to a less than proportionate increase in consumption of food. Thus, the demand for food is income inelastic.
7.3.3 Level Of Income / Stage of Economic Development
Poor people will respond differently from rich people to a rise in their income. For a given rise in income, poor people may buy a lot more butter, whereas rich people may only buy a little more.
7.4 Application: YED
YED is a useful concept to firms to decide on the type of good they should produce based on the economic performance of the country.
If the product has a high YED (>1), sales are likely to expand rapidly as a nation’s gross domestic product (GDP) rises, but may also fall significantly if the economy moves into recession. Thus, for a firm selling luxurious goods, a good time to increase its production would be in times of an economic boom since demand raises more than proportionately compared to income.
On the other hand, this firm should cut back its production on luxurious goods during recession and may choose to introduce a low-end version of the goods because the demand for inferior good rises when income falls.
YED can also be useful to decide on the range of goods sold to differing income goods. It can be based on geographical location, or by occupations, etc.
More application examples taught in lessons.
7.5 Definition of Cross Elasticity of Demand (XED)
Cross elasticity of demand (XED) is defined as the degree of responsiveness of demand for one product to a change in the price of another good, ceteris paribus.
It can be calculated by dividing the percentage change in quantity demanded of one good by the percentage change in price of another.
7.6 Interpretation of XED Values
Positive XED (XED > 0)
If the commodities are substitutes, i.e., butter and margarine, then a decrease in the price of one good will lead to a fall in the quantity demanded for the other and vice-versa.
Note: If 2 goods are close substitutes, the value of XED > 1.
Negative XED (XED <0)
If the commodities are complements, i.e., phones and subscription plans, then a change in the price of one will lead to the change in quantity demanded in the opposite direction.
Note: If 2 goods are close complements, the value of XED < -1.
7.7 Determinants of XED
It is obvious that we are only concerned with goods that are related with each other. The only determinant we are concerned with the degree of substitutability (for substitutes), or the degree of complementarity, (for complements).
The closer one good is a substitute or a complement of another, the bigger the effect on quantity of the first good as the result of a change in the price of a substitute or complement and hence, the greater the XED value.
7.8 Application of XED
Firms will wish to know the XED for their product in relation with other products when considering the effect on the demand for their product to a change in the price of a rival’s or complementary product. These are vital pieces of information for firms to strategize in order to raise revenue or sales.
In general, we focus on the possible range of reaction and action strategies rival firms may have in response, to a firm’s actions.
For rival firms:
The firm will either slash price when the competitors lowers price to prevent consumers from turning to cheaper alternatives or at the same time, the firm should try to differentiate its products such as improving on the quality of the product / service to lower the degree of substitutability between its goods and the competitors.
For partner firms:
Firms can have joint promotion with other firms that sell complements or considering selling complements to attract consumers since when one party lowers price, the other will benefit from a rise in demand.
XED / CED is useful for firms to for considering the effect on the demand for their good given a change in the price of a rival’s product or a complementary product. For eg, two or more airlines competing with each other on a given route. If the first airline cuts the price of its air ticket, the second airline can use estimates of cross price elasticity to predict the effect on the demand and total revenue of their air flights. If the total revenue is adversely affected, the second airline might want to lower his price in response to the the price of its competitors.
In the long run, the producer should try to reduce the substitutability of its product. By doing that, the demand of the good will be more price inelastic and it will also reduce its XED in relation to other substitutes (rivals). This implies that it will not be so easily affected by the price changes of other rivals.
As mentioned earlier, firms can also use XED to determine marketing or pricing strategies for its own product given a change in the price of a complementary good. For example if air ticket is a strong complement to a resort, a fall in the price of air tickets will increase the demand of the overseas hotel. Thus when prices of air tickets fall, the owner of the resort can expect a higher demand and thus prepare more rooms or employ more workers. He can also tie up with airlines with falling prices of air tickets to increase the demand of his resort (bundling).
In conclusion, knowledge of PED, YED and XED allow the firm to be more informed in their decision-making.
7.8.1 Limitations of Elasticity Concepts
However there are limitations in each of the concepts of elasticity. It is therefore wise for firms to consider all the concepts in their decision-making on production level, prices or marketing strategies. Firms also must acknowledge that it is difficult to estimate PED, YED and XED as they will change time to time as factors affecting these elasticities change over time. Furthermore, they have to take into accounts the possible Gov intervention (Mkt Failure), and also the Mkt Structure, when formulating any strategy to earn more revenue.
More application examples taught in lesson. 🙂
7.9 Sample Short Answer Questions
- Explain the differences between YED and XED concept.
- Explain why the YED value for air travel from SG to UK is larger than that of air travel from SG to Vietnam.
- Discuss how might the recession that results from COVID-19 impact producers of organic and non-organic vegetables.
(Ref: Vegetable market in S’pore, Urban Farming Amid COVID-19)
The above questions require your knowledge of the content of basic SS and DD theories, the concepts of YED and / or XED, plus the higher order thinking skills (HOT) examination techniques, especially recognising the hidden need to apply elasticity concepts. More of such HOT assessment skills in our Econs tuition class.