Q. State what is meant by- (i) Income
Elasticity of Demand and cross elasticity of demand (Dec’13).
Income Elasticity of Demand (Dec’13):
The quantity demanded of a particular product depends not only on its own price
and on the price of other related products, but also on other factors such as
income. The purchases of certain commodities may be particularly sensitive to
changes in nominal and real income. The concept of income elasticity of demand
therefore measures the percentage change in quantity demanded of a given
product due to a percentage change in income.
The measures of income elasticity of
demand may be either positive or negative numbers and these have been used to
classify products into "normal" or "inferior goods" or into
"necessities" or "luxuries". If as a result of an increase
in income the quantity demanded of a particular product decreases, it would be
classified as an "inferior" good. The opposite would be the case of a
"normal" good. Margarine has in past studies been found to have a
negative income elasticity of demand indicating that as family income
increases, its consumption decreases possibly due to substitution of butter.
Cross-elasticity of demand (May’11,
May’12, Dec’12, Dec’13 and June’14): In economics, the cross
elasticity of demand or cross-price elasticity of demand measures the responsiveness
of the demand for 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 demand of new cars that
are fuel inefficient decreased by 20%, the cross elasticity of demand would be:
-20%/10%=-2
A negative cross elasticity denotes two
products that are complements, while a positive cross elasticity denotes two
substitute products. These two key relationships may go against one's
intuition, but the reason behind them is fairly simple: assume products A and B
are complements, meaning that an increase in the demand for A is caused by an
increase in the quantity demanded for B. Therefore, if the price of product B
decreases, then the demand curve for product A shifts to the right, increasing
A's demand, resulting in a negative value for the cross elasticity of demand.
The exact opposite reasoning holds for substitutes.
The formula used to calculate the
coefficient cross elasticity of demand is
EA,B= % Change in quantity
demanded of product A/ %change in price of product B
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