Price, Income and Cross Elasticity of Demand

This section covers the key concepts of price elasticity of demand, income elasticity of demand, and cross elasticity of demand. Understanding these elasticities is crucial for analyzing consumer behavior and market responses to changes in price, income, and the price of related goods.

Price Elasticity of Demand (PED)

Price elasticity of demand measures the responsiveness of quantity demanded to a change in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price.

Formula:

$PED = \frac{\text{Percentage Change in Quantity Demanded}}{\text{Percentage Change in Price}}$

Interpretation of PED values:

• Elastic (|PED| > 1): Quantity demanded is highly responsive to price changes. A small price change leads to a relatively large change in quantity demanded.
• Inelastic (|PED| < 1): Quantity demanded is not very responsive to price changes. A price change leads to a relatively small change in quantity demanded.
• Unit Elastic (|PED| = 1): Quantity demanded changes proportionally to the price change.
• Perfectly Elastic (|PED| = Ôê×): Any price increase will lead to zero quantity demanded, and any price decrease will result in infinite quantity demanded.
• Perfectly Inelastic (|PED| = 0): Quantity demanded does not change at all, regardless of the price change.

Factors influencing PED:

• Availability of substitutes
• Necessity vs. luxury
• Proportion of income spent on the good
• Time horizon

Income Elasticity of Demand (YED)

Income elasticity of demand measures the responsiveness of quantity demanded to a change in consumer income. It is calculated as the percentage change in quantity demanded divided by the percentage change in income.

Formula:

$YED = \frac{\text{Percentage Change in Quantity Demanded}}{\text{Percentage Change in Income}}$

Interpretation of YED values:

• Normal Goods (YED > 0): As income increases, quantity demanded increases.
• Luxury Goods (YED > 1): As income increases, quantity demanded increases at a faster rate than income.
• Inferior Goods (YED < 0): As income increases, quantity demanded decreases. Consumers switch to better quality or more desirable alternatives.

Cross Elasticity of Demand (XED)

Cross elasticity of demand measures the responsiveness of quantity demanded of one good to a change in the price of another good. It is calculated as the percentage change in quantity demanded of one good divided by the percentage change in the price of the other good.

Formula:

$XED = \frac{\text{Percentage Change in Quantity Demanded of Good A}}{\text{Percentage Change in Price of Good B}}$

Interpretation of XED values:

• Substitutes (XED > 0): As the price of good B increases, the quantity demanded of good A increases.
• Complements (XED < 0): As the price of good B increases, the quantity demanded of good A decreases.

These elasticities are important tools for businesses to understand how changes in their own prices, consumer incomes, and the prices of competing goods will affect their sales.