INCOME ELASTICITY OF DEMAND
Income Elasticity of Demand for a Normal Good
Rey Mark Y. Gania
BSED – SOCSTUD
Micro & Macro Economics
MWF / 6:15 – 7:15 Pm
Income Elasticity of Demand
The coefficient of Income elasticity of demand
measures a products percentage change in demand as
ration of the percentage change in income, which
caused the shift in the demand curve.
The absolute value of the coefficient of income
elasticity is also a measure of how responsive demand
is to change in income.
Types of Income Elasticity of Demand
We can categorize income elasticity of demand into 5
different categories depending on the value.
Normal goods have a positive income elasticity of
demand so as consumers’ income increase, there is an
increase in quantity demand.
Necessities have an income elasticity of demand of
between 0 and +1. For example, a staple like rice or
bread could be considered a necessity.
Inferior goods have a negative income elasticity of
demand meaning that demand falls as income rises.
1.
A normal good has an Income Elasticity of Demand > 0.
This means the demand for a normal good will increase
as the consumer’s income increases.
2. Income Elasticity of Demand for an Inferior Good
An inferior good has an Income Elasticity of Demand <
0. This means the demand for an inferior good will
decrease as the consumer’s income decreases.
3. Income Elasticity of Demand for a Luxury Good
Luxury goods usually have Income Elasticity of Demand
> 1, which means they are income elastic. This implies
that consumer demand is more responsiveness to a
change in income. For example, diamonds are a luxury
good that are income elastic.
Examples of Income Elasticity of Demand
Example 1
Genovia has experienced exceptional growth in recent
years. Its GDP per capita has increased from around
$30,000 to $50,000 in last 5 years. Over the period
quantity demanded of personal cars has increased
from 450,000 units per year to 600,000 units. Quantity
demanded of public transport, however, has declined
from 10,000 buses to 7,000 buses. Calculate cross
elasticity of demand and tell which product is a normal
good and which one is inferior.
Percentage increase in income level
= ($50,000-$30,000) ÷ {($50,000+$30,000)/2}
= 50%
Percentage increase in quantity demanded of cars
= (600,000-450,000) ÷ {(600,000+450,000)/2}
= 28.57%
Percentage increase in quantity demanded of buses
= (7,000-10,000) ÷ {(7,000+10,000)/2}
= -35.29%
Cross elasticity of demand of cars
= 28.57%/50%
= 0.57
Cross elasticity of demand of buses
= -35.29%/50%
= -0.71

Since cars have positive income elasticity of demand,
they are normal goods (also called superior goods)
while buses have negative income elasticity of demand
which indicates they are inferior goods.
Example 2: An example of a product with positive
income elasticity could be Ferraris. Let's say the
economy is booming and everyone's income rises by
400%. Because people have extra money, the quantity
of Ferraris demanded increases by 15%.
We can use the formula to figure out the income
elasticity for this Italian sports car:
Income Elasticity = 15% / 400% = 0.0375
Example 3: An example of a good with negative income
elasticity could be cheap shoes. Let's again assume the
economy is doing well and everyone's income rises by
30%. Because people have extra money and can afford
nicer shoes, the quantity of cheap shoes demanded
decreases by 10%.
The income elasticity of cheap shoes is:
Income Elasticity = -10% / 30% = -0.33
Cross Elasticity of Demand
Cross elasticity of demand is the ratio of percentage
change in quantity demanded of a product to
percentage change in price of another product. It is
used to measure how responsive the quantity
demanded of one product is to a change in price of
another product.
Cross elasticity of demand indicates whether any two
products are substitute goods, complementary goods
or independent goods. A positive cross elasticity of
demand means that the products are substitute goods.
A negative cross elasticity of demand means that the
products are complementary goods. A near zero cross
elasticity of demand means that the products are
independent goods i.e. quantity demanded of product
A is not affected by any movement in price of product
B.
Formula
Percentage changes in the above formula are
calculated using the mid-point formula which divides
actual change by average of initial and final values.
The formula to calculate cross elasticity thus becomes:
Where,
Qf and Qi are the final and initial quantities demanded
of product A, respectively; and Pf and Pi are the final
and initial prices of product B.
Substitute Goods
When the cross elasticity of demand for product A
relative to a change in price of product B is positive, it
means that in response to an increase (decrease) in
price of product B, the quantity demanded of product
A has increased (decreased). Since A, say Coke, and B,
say Sprite, are substitutes, an increase in price of
product B means that more people will consume A
instead of B, and this will increase the quantity
demanded of product A. Increase in quantity
demanded of product A relative to increase in price of
product B gives us a positive cross elasticity of demand.
Complimentary Goods
When the cross elasticity of demand for product A
relative to change in price of product B is negative, it
means that the quantity demanded of A has decreased
(increased) relative to an increase (decrease) in price
of product B. As A, say car, and B, say gas, are
complimentary goods, and an increase in price of B will
reduce the quantity demanded of A. This is because
people consume both A and B as a bundle and an
increase in price reduces their purchasing power and
decreases quantity demanded.
Examples
Example 1: The quantity demanded or product A has
increased by 12% in response to a 15% increase in price
of product B. Calculate the cross elasticity of demand
and tell whether the product pair is (a) apples and
oranges, or (b) cars and gas.

Cross elasticity of demand = % change in quantity

demanded of A ÷ % change in price of B = 12%/15% =
0.67.

Since the cross elasticity of demand is positive, product

A and B are substitute goods. They are most likely
apples and oranges.

Example 2: The government of Selgina is very serious

about drugs. Possession of drugs is illegal and is
severely penalized. However, a black market exists
which the government has failed to dismantle despite
serious attempts. Khusenichho Chamling, the health
minister, is worried about the situation. In early 2009,
a consultant working with health ministry suggested
that the government should increase the price of a
pack of cigarettes from 200 Selgina dollars (S$) to
S$600. A survey conducted in December 2009
suggested that over the year, the quantity demanded
of marijuana decreased from 2,000 kgs per day to just
800 kgs. Calculate the cross elasticity of demand and
tell why has the policy proved so effective.

Percentage increase in price of cigarettes = (600-200) ÷

{(600+200) ÷ 2} = 100%

Percentage increase in quantity demanded of

marijuana = (800-2,000) ÷ {(800+2000) ÷ 2} = -85.71%

Cross elasticity of demand = % change in quantity

demanded/% change in price = -85.71%/100% = -0.86

Cigarettes and marijuana have negative cross elasticity

of demand which tells that they are complimentary
goods.

The policy has proved effective because cigarettes and

marijuana are consumed together. Increase in price of
cigarettes increased the price of the whole bundle and
reduced the purchasing power of people and resulted
in a drop in consumption of marijuana.