INCOME ELASTICITY OF DEMAND

Chapter 3

Income elasticity of demand measures a products percentage change in demand as a ratio of percentage change in income which caused the shift in demand curve.

The absolute value of the coefficient of income elasticity is also a measure of how responsive is demand to the change in income.

 > 1 demand is elastic and the good is superior < 1 demand is inelastic and the good is inferior = 1 means demand is unitary and the good is normal.

Earnest Engel study the income elasticity of food and found out that when income increases, the percentage spent on food tends to decrease. This is known as Engels Law.

When income increases, the increase normally goes to luxury items.

An elasticity greater than 1 means that the product gains importance in the allocation of incremental income.

On the other hand, some products lose importance because others do otherwise as income increases. Such product is inferior because the elasticity is less than 1.

The Consumption Line

The above figure is a hierarchy of budget lines and indifferent curves which determine the different levels of consumption. The curves connecting these points of tangency represents the consumption of two commodities.

The consumption line is upward sloping from the point of origin. The commodity with elasticity greater than 1 is superior.

There are two reasons for the change in relative importance of the commodity items as income continues to increase.

1.

2.

Ones gradual satisfaction of the consumers hierarchy of needs from the basic to the non-basic. Smaller budget can constrain a consumer from consuming goods of better quality due to higher prices and the consumption of which is only possible at higher income level.

Cross Elasticity of Demand

The coefficient of cross elasticity of demand measures the percentage change in the demand of Good X which is a shift of the demand curve in response to the change in price of Good Y .

Such goods may be related as substitutes or complements.

If elasticity is negative Goods X and Y are substitutes. This means that an increase in the price of Good X will increase the purchase of Good Y .

If elasticity is positive, the products are complements. This means that an increase in price of Good X will lead to decreased purchases of Good Y .

Demand curve and elasticity:

This is perfectly elastic, at a given price, quantity demanded can change infinitely.

This is perfectly inelastic. At any price, the quantity demanded will remain the same.

This is relatively elastic demand where a change in price leads to significant change in demand.

This is relatively inelastic, where a change in price leads to very slight change in quantity demanded.

PRICE ELASTICITY OF SUPPLY

Supply also change as response to the change in prices.

The difficulty or ease of increasing or decreasing supply of goods determines its elasticity. Goods that are relatively easy to manufacture have elastic supplies; whereas goods, which are difficult to produce have inelastic supplies.

If elasticity of supply is:

> 1, elastic < 1, inelastic = 1, it is unitary

Relative elastic- a change in price results in a significant change in quantity supplied.

Relatively inelastic a change in price will cause a slight change in quantity supplied.

Perfectly Inelastic quantity supplied may change indefinitely.

Perfectly elastic at a given price, quantity supplied remains constant.