Elasticity of Demand

Objectives To understand and be able to calculate income and cross price elasticity of demand Be able to evaluate the business relevance of these elasticity estimates

Income and Cross Price Elasticity

Income Elasticity of Demand Measures the responsiveness of quantity demanded to changes in income % ∆ QD % ∆ Y YED =

Normal Goods An increase in income will lead to an increase in demand They have a positive income elasticity Examples? Necessities have low YED (0-0.5) WHY? Superior/ luxury goods have a high YED (greater than 1) Note: descriptions of elasticity still apply: 0 means demand is perfectly inelastic with respect to a change in income 2 would indicate demand is elastic with respect to a change in income and the good is a luxury item

Inferior Goods An increase in income will lead to a decrease in demand They have a negative income elasticity Egs. Bus transport- consumers switch from buses to cars when they can afford their own cars Other examples?

D normal good D inferior good D good- normal at low levels of income and inferior at higher levels of income Quantity Income

Question Calculate the Income elasticity of demand. Comment on the type of good £ OriginalNew Q DemandedIncomeQ DemandedIncome

A consumer had an increase in her income from £80000 to £ p.a. In the following year, her expenditure on holidays increased from £8000 to £10000, her expenditure on gym member ship remained the same and her expenditure on locally produced clothing fell from £2000 to £ Calculate her YED for holidays and explain what this means 2. Calculate her YED for gym membership and explain what this means 3. Calculate her YED for locally produced clothes and explain what this means

Business Significance? When the economy is doing well, and incomes are rising, what products will do well? Think of other situations...

Cross Price Elasticity of Demand Measures the responsiveness of the quantity demanded of one good to changes in the price of another Complements eg. Bread and butter Substitutes eg. Beef and chicken % ∆ QD of good X % ∆ P of good Y Note: a figure of 0 indicates no relationship

Goods which are Substitutes Goods which are Complements Type of XPED (positive or negative?) Explanation As the price of one good rises, the demand for substitute good _____________ As the price of one good rises, the demand for the complement good _______________

Positive or Negative XED? Gas and electricity Tennis shorts and tennis rackets Luxury cars and petrol Cold Storage own baked beans and Tescos own baked beans Pepsi and Coca Cola

“Light- Bites” a sandwich shop finds that when it’s rival “Super-Snack” reduces the price of it’s chicken wraps from £5 to £4.60, the demand for “Light- Bites” sandwiches falls from 400 to 340 sandwiches a week. In addition, “Super- Snack” finds that following the fall in the price of their chicken wraps, the demand for soft drinks rises from 600 cans to 630 cans per week 1. Calculate the XED between “Light- Bites” sandwiches and “Super- Snack” sandwiches. Explain the relationship.. 2. Calculate the XED between “Super-Snack” sandwiches and drinks. Explain the relationship

Business Significance? Firms need to be aware of the XPED for the products they sell hence aware of the possible impact a close competitor may have when they change the price of their product and vice versa Also, firms selling complementary or substitute products need to be aware of the effects that any price change for a good has on the demand for the related products it sells Eg. If a café put the price of coffee up it would be able to estimate the impact that would have on the demand for chocolate cake

Quick Calculations Calculate the percentage change in demand in each of the following cases: Yed is 2.4 and the % Δ Y is 5% Xed is -1.5 and the % Δ Price of good y is 20% Ped is -0.6 and the % Δ P is 18% Yed is and the % Δ Y is 8% Where appropriate say whether the good is a normal good or an inferior good, or whether it is a substitute or complement.