ECONOMIC ANALYSIS

Module 2. Theory of demand

Lesson 11
INCOME ELASTICITY AND CROSS ELASTICITY

11.1 Introduction

This lesson describes the concept of income elasticity of demand. There are five different types of income elasticity of demand. There are three different methods for measurement of income elasticity of demand.

11.2 Income Elasticity of Demand

Apart from price of the commodity, income of consumer is also important factor affecting demand. Thus income elasticity of demand is defined as ratio of proportional or percentage change in quantity demanded to the proportional or percentage change in income.

Mathematically it is represented as

11.3 Classification of Income Elasticity

Following table gives classification of Income elasticity.

Table 11.1 Classification of Income elasticity

11.3.1 Cross elasticity of demand

In case of price and income elasticity, commodities price and consumers income are considered as determinants of demand respectively. A demand for a commodity is also affected by price and availability of related goods. Related goods are either substitutes or complimentary goods. Two goods are called substitute goods if they can be used to satisfy same human want. Two goods are called complimentary goods if both are required to be used simultaneously to satisfy human want. The concept of cross elasticity is defined as responsiveness of demand for a good with respect to change in price of a related good. In mathematical form cross elasticity is given by

The concept of cross elasticity is useful to know the relationship between commodities viz., substitute, complimentary or unrelated.

Following Table-11.2 shows the relationship between type of cross elasticity of goods.

Table 11.2 Relationship between type of cross elasticity of goods

The above mentioned relationship is duplicated in graphical form in Fig 11.1

11.4 Utility of Elasticity of Demand

The concept of utility is helpful to modern business men in setting price of their product. It is helpful to government to frame a suitable tax policy in order to realize the necessary tax revenue. It is helpful to policymakers and trade unions to adjust their policies to benefit the members. The concept is also helpful in international trade.

11.4.1 Measurement of elasticity

The following methods are used to measure elasticity.

Ratio method: It is also referred to as percentage method or proportion method. It is measured by calculating ratio of the relative changes in demand and price varieties.

(a) Total revenue or total expenditure method: In this method, elasticity of demand is measured by examining the change in total expenditure corresponding to change in price of the commodity.

(b) Geometric method: In this method elasticity is measured at a point on the demand curve.

This shown in Fig 11.2

If the demand curve is not a straight line then by drawing tangent elasticity is measured.

Let the straight line demand curve be extended to meet the two axis as shown in Figure 11.2(a). When a point is plotted on demand curve like point C in Figure 11.2(a), it divides the curve into two segments. The point elasticity is thus measured by the ratio of lower segment of the curve below the given point to the upper segment of the curve above the point. If the demand curve is non linear, then draw a tangent at the given point, extending it to intercept both the axes as shown in Figure 11.2(b). Point elasticity is thus measured by the ratio of the lower point of the tangent below the given point to the upper part of the tangent above the point.