67 Income Elasticity, Cross-Price Elasticity & Other Types of Elasticities
67 Income Elasticity, Cross-Price Elasticity & Other Types of Elasticities
What you’ll learn to do: explain and calculate other elasticities using common economic variables
Remember, elasticity measures the responsiveness of one variable to changes in another variable. We have focused on how a change in price can impact other variables. Elasticity doesn’t apply only to price, however. It can describe anything that affects demand or supply. For example, when consumer income varies, it can have an impact on demand. When we consider that impact, we are measuring the responsiveness of one variable (demand) to changes in another variable (consumer income). This is called the income elasticity of demand.
Likewise, if two goods are complements or substitutes, a change in demand for one can have an impact on the demand for the other. This is known as cross-price elasticity of demand. In this section, we’ll elaborate on the idea of elasticity to see how it applies to other economic variables.
Learning Objectives
- Calculate the income elasticity of demand
- Explain and calculate cross-price elasticity of demand
- Describe elasticity in labor and financial capital markets
The basic idea of elasticity—how a percentage change in one variable causes a percentage change in another variable—does not just apply to the responsiveness of supply and demand to changes in the price of a product. Recall that quantity demanded (Qd) depends on income, tastes and preferences, population, expectations about future prices, and the prices of related goods. Similarly, quantity supplied (Qs) depends on the cost of production, changes in weather (and natural conditions), new technologies, and government policies. Elasticity can, in principle, be measured for any determinant of supply and demand, not just the price.
Income Elasticity of Demand
The income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income, as follows:
[latex]\text{income elasticity of demand}=\frac{\text{percent change in quantity demanded}}{\text{percent change in income}}[/latex]
For most products, most of the time, the income elasticity of demand is positive: that is, a rise in income will cause an increase in the quantity demanded. This pattern is common enough that these goods are referred to as normal goods. However, for a few goods, an increase in income means that one might purchase less of the good; for example, those with a higher income might buy fewer hamburgers, because they are buying more steak instead, or those with a higher income might buy less cheap wine and more imported beer. When the income elasticity of demand is negative, the good is called an inferior good. The concepts of normal and inferior goods were introduced in the Supply and Demand module. A higher level of income for a normal good causes a demand curve to shift to the right for a normal good, which means that the income elasticity of demand is positive. How far the demand