EQ: What is Income Elasticity of Demand?

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1 EQ: What is Income Elasticity of Demand? Changes in Consumer Income shift the demand curve: Normal Goods goods that are more desirable to consumers; when people have more money, they buy more normal goods Increase in income shifts demand curve to right Decrease in income shifts demand curve to left Inferior Goods goods that are barely acceptable replacements for normal goods; when people have less money, they switch from normal goods to inferior goods Increase in income shifts demand curve to left (buyers leave the market to buy normal goods) Decrease in income shifts demand curve to right (buyers enter the market because they can t afford normal goods)

2 EQ: What is Income Elasticity of Demand? Income Elasticity of Demand (EY) is a characteristic of a product describing: Whether people will buy more or less of the product due to a change in buyers incomes. The degree of the increase or decrease in sales due to a change in buyers incomes. Income Elasticity: When people have more money, they usually buy more luxuries and fewer inferior goods. When people have less money, they usually buy fewer luxuries and more inferior goods.

3 EQ: How Do I Calculate Income Income Elasticity of Demand (EY) measures the relative change in quantity demanded in response to changes in consumer income. Formula: Elasticity of Demand? Change in Quantity Demanded Average Quantity Demanded Change in Income Average Income *See the textbook Chapter 17 for more examples on how to calculate Income Elasticity of Demand.

4 EQ: How Do I Calculate Income Example: Elasticity of Demand? When consumers incomes increase from $2,800 to $2,900 per month, quantity demanded of cell phones increases from 4,000 to 4,300. What is the income elasticity of demand? Q2 Q (Q2 + Q1)/2 ( )/ % EY = = 2.06 Y2 Y % (Y2 + Y1)/2 ( )/2 2850

5 EQ: How Do I Calculate Income Example: Elasticity of Demand? When consumers incomes increase from $1,100 to $1,300 per month, quantity demanded of Ramen noodles decreases from 700 to 550. What is the income elasticity of demand? Q2 Q (Q2 + Q1)/2 ( )/ % EY = = Y2 Y % (Y2 + Y1)/2 ( )/2 1200

6 EQ: What Does the IED Number Mean? Income Elasticity of Demand (EY) can be either a positive or negative value: A positive value means that the good is not an inferior good: Between 0 and 1 means that it is a normal good. Greater than 1 means that it is a luxury good. A negative number means that the good is an inferior good (and not a normal good) A value of zero means that demand for the good is unresponsive to a change in income.

7 EQ: What is Cross Elasticity of Demand? Prices of Related Goods will cause the demand curve to shift: Complements goods that are usually purchased along with the one being sold in the market Example: Peanut Butter is a complement to Jelly An increase in the price of a complement shifts demand to the left (decreased demand because the increase in price led to a decrease in the Qd for the complement) A decrease in price of a complement shifts demand to the right (increased demand because the decrease in price led to an increase in the Qd for the complement)

8 EQ: What is Cross Elasticity of Demand? Prices of Related Goods will cause the demand curve to shift: Substitutes goods that replace the one being sold in the present market Example: Taking the city bus is a substitute for buying a car An increase in price of a substitute shifts demand to the right (increased demand because the increase in price led to a decrease in the Qd for the substitute) The demand then moves from the substitute to our good A decrease in price of a substitute shifts demand to the left (decreased demand because the decrease in price led to an increase in the Qd for the substitute) The demand moves from our good to the substitute

9 EQ: What is Cross Elasticity of Demand? Cross Elasticity of Demand (EC) is a characteristic of a product describing: Whether people will buy more or less of the product due to a change in the price of a related product. How closely related two products are. Cross Elasticity: When the price of a substitute goes up, demand for the product goes up. When the price of a complement goes up, demand for the product goes down.

10 EQ: How Do I Calculate Cross Elasticity of Demand? Cross Elasticity of Demand (EC) measures the relative change in quantity demanded for one good in response to a price change in a related good (complement or substitute). Formula: Change in Quantity Demanded Good X Average Quantity Demanded Good X Change in Price Good Y Average Price Good Y *See the textbook Chapter 17 for more examples on how to calculate Cross Elasticity of Demand.

11 EQ: How Do I Calculate Cross Example: Elasticity of Demand? The price of airline tickets decreases from $300 to $270 and the demand for hotel rooms increases from 400 to 650. What is the cross elasticity of demand? Q2 Q (Q2 + Q1)/2 ( )/ % EC = = P2 P % (P2 + P1)/2 ( )/2 285

12 EQ: How Do I Calculate Cross Example: Elasticity of Demand? The price of vacation home rentals decreases from $500 to $450 and the quantity demanded for hotel rooms decreases from 500 to 400. What is the cross elasticity of demand? Q2 Q (Q2 + Q1)/2 ( )/ % EC = = 2.11 P2 P % (P2 + P1)/2 ( )/2 475

13 EQ: What Does the CED Number Mean? Cross Elasticity of Demand (EC) can be either a positive or negative value: A positive value means that the two goods in question are substitutes for one another. Vacation home rentals and hotel rooms have a cross elasticity of demand of This is positive, so they are substitutes for one another. A negative number means that the two goods in question are complements to one another. Airline tickets and hotel rooms have a cross elasticity of demand of This is negative, so they are complements to one another.