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February 20, 2018

Price, Income and Cross Elasticity of Demand

February 20, 2018


Elasticity is the degree of responsiveness of one variable to a change in another variable. In economics, elasticity of demand refers to a change in quantity demanded for a good due to change in its price. This change may be small or great. Following are the kinds of elasticity of demand.

1. Price Elasticity of Demand
2. Income Elasticity of Demand
3. Cross Elasticity of demand

1. Price Elasticity of Demand

Price elasticity of demand is the degree of responsiveness of quantity demanded of a good or service due to change in its price.  It is commonly known as elasticity of demand. It has the following kinds.

a. Unitary elastic demand
b. Elastic demand
c. Perfectly elastic demand
d. Inelastic demand
e. Perfectly inelastic demand

a. Unitary Elastic Demand
Unitary elastic demand refers to when demand changes with the same proportion in response to a change in its price. For instance, if the price of a good increases by 20% and the demand for that good in response also decreases by 20% or if the price of a good decreases by 20% and the demand for that good in response also increases by 20% as shown in given below figure (1.6).

Unitary elastic demand


 b. Elastic Demand
Elastic demand is the greater change in demand in response to a small change in its price. For example, if the price of a good increases by 30% and the demand for that good in response decreases by 60% or if the price of a good decreases by 30% and the demand for that good in response increases by 60% as shown in given below figure (1.7).

Elastic demand


c. Perfectly Elastic Demand
The demand is said to be perfectly elastic if it increases or decreases even though the price does not change.  Luxury gods are the examples of it which demand expands or contracts even the price remains constant. The following diagram (1.8) is representing perfectly elastic demand.

Perfectly elastic demand curve

d. Inelastic Demand
Inelastic demand is the small change in demand in response to a greater change in its price. For example, if the price of a good increases by 20% and the demand for that good in response decreases by 5% or if the price of a good decreases by 20% and the demand for that good in response increases by 5% as shown in given below figure (1.9).

Inelastic demand curve

e. Perfectly Inelastic Demand
The demand is said to be perfectly inelastic if it remains constant in response to changes in its price. Medicine is the example of it which demand does not change whatever the price of it. The given below diagram (2) is showing perfectly inelastic demand. 

Perfectly inelastic demand curve


Measurement of Price Elasticity of Demand

Price elasticity of demand can be measured by using the following formula:

Elasticity of demand   =   Percentage of change in quantity demanded
                                            Percentage of change in price 


Percentage of change in quantity demanded   =   Change in quantity demanded    X    100
                                                                         Original quantity demanded


Percentage of Change in price     =   Change in price    X    100
                                                         Original price


Example:
Suppose, the price of a washing machine falls from Rs. 10,000 to Rs. 9000, due to fall in price, the quantity demanded for washing machine rises from 2000 to 4000. Now we will measure the price elasticity of demand by using above formula.

Change in quantity demanded   =   4000 – 2000

Change in quantity demanded   =   2000


Percentage of change in quantity demanded   =   2000    X    100    
                                                                       4000

Percentage of change in quantity demanded   =   50%

Change in price   =   10000 – 9000

Change in price   =   1000

Percentage of change in price   =    1000        X    100
                                                   10000                                  

Percentage of change in price    =    10%


Elasticity of demand   =   50
                                      10

Elasticity of demand   =   5% 


2. Income Elasticity of Demand

The demand for a good or service is also affected by income of the consumer. When the income of a consumer changes, the quantity demanded of a good he intends to buy also changes while keeping all other things constant.  Following points should be noted:

a. Income elasticity of demand for normal goods is positive. An increase in income of the consumer will lead to rise in demand for normal goods.

b. Income elasticity of demand for inferior goods is negative. An increase in income of the consumer will lead to fall in demand for inferior goods and may rise demand for luxury goods.

c. A zero income elasticity of demand occurs when demand remains constant while there is an increment in income of the consumer. 

Income elasticity of demand can be measured by using the following formula:

Income elasticity of demand   =   Percentage of change in quantity demanded
                                                         Percentage of change in price


Example:
Suppose, income of the consumer increases by 5% which leads to increase the quantity demanded for vegetables by 10%. Thus, the income elasticity of demand will be:

Income elasticity of demand   =   10%    =   2%
                                                 5%


3. Cross Elasticity of Demand

When the demand of one good changes due to change in the price of other related good is called cross elasticity of demand. It has the following kinds.

a. Cross elasticity of substitutes: The cross elasticity of demand for substitute goods is positive because when the price of one good increases (say coffee), it leads to increase the demand of other related good (say tea).  

b. Cross elasticity of complementary goods:  The cross elasticity of demand for complementary goods is negative because when the price of one good increases (say tyre), it leads to decrease the demand of other related good (say tube). 

Cross elasticity of demand of two related goods can be measured by using the following formula:

Cross elasticity of demand   =   Percentage of change in quantity demanded of good X
                                                      Percentage of change in price of good Y

Example:
Suppose, the price of coffee increases by 20% which leads to increase the quantity demanded for tea by 30%. Thus, the cross elasticity of demand will be:


Cross elasticity of demand   =   30%   =   1.5%
                                              20%    
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