Income Elasticity of Demand

The Income Elasticity of Demand measures the rate of response of quantity demand due to a raise (or lowering) in a consumers income. The formula for the Income Elasticity of Demand (IEoD) is given by: IEoD = (% Change in Quantity Demanded)/(% Change in Income) Calculating the Income Elasticity of Demand On an assignment or a test, you might be asked "Given the following data, calculate the income elasticity of demand when a consumer's income changes from $40,000 to $50,000". (Your course may use the more complicated Arc Income Elasticity of Demand formula. If so you'll need to see the article on Arc Elasticity)Using the chart on the bottom of the page, I'll walk you through answering this question. The first thing we'll do is find the data we need. We know that the original income is $40,000 and the new price is $50,000 so we have Income(OLD)=$40,000 and Income(NEW)=$50,000. From the chart we see that the quantity demanded when income is $40,000 is 150 and when the price is $50,000 is 180. Since we're going from $40,000 to $50,000 we have QDemand(OLD)=150 and QDemand(NEW)=180, where "QDemand" is short for "Quantity Demanded". So you should have these four figures written down: Income(OLD)=40,000 Income(NEW)=50,000 QDemand(OLD)=150 QDemand(NEW)=180 To calculate the price elasticity, we need to know what the percentage change in quantity demand is and what the percentage change in price is. It's best to calculate these one at a time. Calculating the Percentage Change in Quantity Demanded The formula used to calculate the percentage change in quantity demanded is: [QDemand(NEW) - QDemand(OLD)] / QDemand(OLD) By filling in the values we wrote down, we get: [180 - 150] / 150 = (30/150) = 0.2 So we note that % Change in Quantity Demanded = 0.2 (We leave this in decimal terms. In percentage terms this would be 20%) and we save this figure for later. Now we need to calculate the percentage change in price. Calculating the Percentage Change in Income Similar to before, the formula used to calculate the percentage change in income is: [Income(NEW) - Income(OLD)] / Income(OLD) By filling in the values we wrote down, we get: [50,000 - 40,000] / 40,000 = (10,000/40,000) = 0.25 We have both the percentage change in quantity demand and the percentage change in income, so we can calculate the income elasticity of demand. 1|Page

Final Step of Calculating the Income Elasticity of Demand We go back to our formula of: IEoD = (% Change in Quantity Demanded)/(% Change in Income) We can now fill in the two percentages in this equation using the figures we calculated earlier. IEoD = (0.20)/(0.25) = 0.8 Unlike price elasticities, we do care about negative values, so do not drop the negative sign if you get one. Here we have a positive price elasticity, and we conclude that the income elasticity of demand when income increases from $40,000 to $50,000 is 0.8. How Do We Interpret the Income Elasticity of Demand? Income elasticity of demand is used to see how sensitive the demand for a good is to an income change. The higher the income elasticity, the more sensitive demand for a good is to income changes. A very high income elasticity suggests that when a consumer's income goes up, consumers will buy a great deal more of that good. A very low price elasticity implies just the opposite, that changes in a consumer's income has little influence on demand. Often an assignment or a test will ask you the follow up question "Is the good a luxury good, a normal good, or an inferior good between the income range of $40,000 and $50,000?" To answer that use the following rule of thumb: If IEoD > 1 then the good is a Luxury Good and Income Elastic If IEoD < 1 and IEOD > 0 then the good is a Normal Good and Income Inelastic If IEoD < 0 then the good is an Inferior Good and Negative Income Inelastic In our case, we calculated the income elasticity of demand to be 0.8 so our good is income inelastic and a normal good and thus demand is not very sensitive to income changes. DataIncome $20,000 $30,000 $40,000 $50,000 $60,000 Quantity Demanded 60 110 150 180 200

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Cross-Price Elasticity of Demand

The Cross-Price Elasticity of Demand measures the rate of response of quantity demanded of one good, due to a price change of another good. If two goods are substitutes, we should expect to see consumers purchase more of one good when the price of its substitute increases. Similarly if the two goods are complements, we should see a price rise in one good cause the demand for both goods to fall. Your course may use the more complicated Arc Cross-Price Elasticity of Demand formula. If so you'll need to see the article on Arc Elasticity. The common formula for the CrossPrice Elasticity of Demand (CPEoD) is given by: CPEoD = (% Change in Quantity Demand for Good X)/(% Change in Price for Good Y) Calculating the Cross-Price Elasticity of Demand CPEoD = (% Change in Quantity Demand for Good X)/(% Change in Price for Good Y) Calculating the Cross-Price Elasticity of Demand You're given the question: "With the following data, calculate the cross-price elasticity of demand for good X when the price of good Y changes from $9.00 to $10.00." Using the chart on the bottom of the page, we'll answer this question. We know that the original price of Y is $9 and the new price of Y is $10, so we have Price(OLD)=$9 and Price(NEW)=$10. From the chart we see that the quantity demanded of X when the price of Y is $9 is 150 and when the price is $10 is 190. Since we're going from $9 to $10, we have QDemand(OLD)=150 and QDemand(NEW)=190. You should have these four figures written down: Price(OLD)=9 Price(NEW)=10 QDemand(OLD)=150 QDemand(NEW)=190 To calculate the cross-price elasticity, we need to calculate the percentage change in quantity demanded and the percentage change in price. We'll calculate these one at a time. Calculating the Percentage Change in Quantity Demanded of Good X The formula used to calculate the percentage change in quantity demanded is: [QDemand(NEW) - QDemand(OLD)] / QDemand(OLD) By filling in the values we wrote down, we get: [190 - 150] / 150 = (40/150) = 0.2667 So we note that % Change in Quantity Demanded = 0.2667 (This in decimal terms. In percentage terms this would be 26.67%). Calculating the Percentage Change in Price of Good Y The formula used to calculate the percentage change in price is: [Price(NEW) - Price(OLD)] / Price(OLD) We fill in the values and get: [10 - 9] / 9 = (1/9) = 0.1111 3|Page

We have our percentage changes, so we can complete the final step of calculating the cross-price elasticity of demand. Final Step of Calculating the Cross-Price Elasticity of Demand We go back to our formula of: CPEoD = (% Change in Quantity Demanded of Good X)/(% Change in Price of Good Y) We can now get this value by using the figures we calculated earlier. CPEoD = (0.2667)/(0.1111) = 2.4005 We conclude that the cross-price elasticity of demand for X when the price of Y increases from $9 to $10 is 2.4005. How Do We Interpret the Cross-Price Elasticity of Demand? The cross-price elasticity of demand is used to see how sensitive the demand for a good is to a price change of another good. A high positive cross-price elasticity tells us that if the price of one good goes up, the demand for the other good goes up as well. A negative tells us just the opposite, that an increase in the price of one good causes a drop in the demand for the other good. A small value (either negative or positive) tells us that there is little relation between the two goods. Often an assignment or a test will ask you a follow up question such as "Are the two goods complements or substitutes?". To answer that question, you use the following rule of thumb: If CPEoD > 0 then the two goods are substitutes If CPEoD =0 then the two goods are independent (no relationship between the two goods If CPEoD < 0 then the two goods are complements In the case of our good, we calculated the cross-price elasticity of demand to be 2.4005, so our two goods are substitutes when the price of good Y is between $9 and $10.

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Arc Elasticity
One of the problems with the standard formulas for elasticity that are in many freshman texts is the elasticity figure you come up with is different depending on what you use as the start point and what you use as the end point. An example will help illustrate this. When we looked at Price Elasticity of Demand we calculated the price elasticity of demand when price went from $9 to $10 and demand went from 150 to 110 was 2.4005. But what if we calculated what the price elasticity of demand when we started at $10 and went to $9? So we'd have: Price(OLD)=10 Price(NEW)=9 QDemand(OLD)=110 QDemand(NEW)=150 First we'd calculate the percentage change in quantity demanded: [QDemand(NEW) QDemand(OLD)] / QDemand(OLD) By filling in the values we wrote down, we get: [150 - 110] / 110 = (40/110) = 0.3636 (Again we leave this in decimal form) Then we'd calculate the percentage change in price: [Price(NEW) - Price(OLD)] / Price(OLD) By filling in the values we wrote down, we get: [9 - 10] / 10 = (-1/10) = -0.1 We then use these figures to calculate the price-elasticity of demand: PEoD = (% Change in Quantity Demanded)/(% Change in Price) We can now fill in the two percentages in this equation using the figures we calculated earlier. PEoD = (0.3636)/(-0.1) = -3.636 When calculating a price elasticity, we drop the negative sign, so our final value is 3.636. Obviously 3.6 is a lot different from 2.4, so we see that this way of measuring price elasticity is quite sensitive to which of your two points you choose as your new point, and which you choose as your old point. Arc elasticities are a way of removing this problem. When calculating Arc Elasticities, the basic relationships stay the same. So when we're calculating Price Elasticity of Demand we still use the basic formula: PEoD = (% Change in Quantity Demanded)/(% Change in Price) However how we calculate the percentage changes differ. Before when we calculated Price Elasticity of Demand, Price Elasticity of Supply,Income Elasticity of Demand, or Cross-Price Elasticity of Demand we'd calculate the percentage change in Quantity Demand the following way: 5|Page

[QDemand(NEW) - QDemand(OLD)] / QDemand(OLD) To calculate an arc-elasticity, we use the following formula: [[QDemand(NEW) - QDemand(OLD)] / [QDemand(OLD) + QDemand(NEW)]]*2 This formula takes an average of the old quantity demanded and the new quantity demanded on the denominator. By doing so, we will get the same answer (in absolute terms) by choosing $9 as old and $10 as new, as we would choosing $10 as old and $9 as new. When we use arc elasticities we do not need to worry about which point is the starting point and which point is the ending point. This benefit comes at the cost of a more difficult calculation. If we take the example with: Price(OLD)=9 Price(NEW)=10 QDemand(OLD)=150 QDemand(NEW)=110 We will get a percentage change of: [[QDemand(NEW) - QDemand(OLD)] / [QDemand(OLD) + QDemand(NEW)]]*2 [[110 - 150] / [150 + 110]]*2 = [[-40]/[260]]*2 = -0.1538 * 2 = -0.3707 So we get a percentage change of -0.3707 (or -37% in percentage terms). If we swap the old and new values for old and new, the denominator will be the same, but we will get +40 in the numerator instead, giving us an answer of the 0.3707. When we calculate the percentage change in price, we will get the same values except one will be positive and the other negative. When we calculate our final answer, we will see that the elasticities will be the same and have the same sign. To conclude this piece, I'll include the formulas so you can calculate the arc versions of price elasticity of demand, price elasticity of supply, income elasticity, and cross-price demand elasticity. I recommend calculating each of the measures using the step-by-step fashion I detail in the previous articles. New Formulas - Arc Price Elasticity of Demand To calculate the Arc Price Elasticity of Demand, we use the formulas: PEoD = (% Change in Quantity Demanded)/(% Change in Price) (% Change in Quantity Demanded) = [[QDemand(NEW) - QDemand(OLD)] / [QDemand(OLD) + QDemand(NEW)]] *2] (% Change in Price) = [[Price(NEW) - Price(OLD)] / [Price(OLD) + Price(NEW)]] *2] New Formulas - Arc Price Elasticity of Supply To calculate the Arc Price Elasticity of Supply, we use the formulas: PEoS = (% Change in Quantity Supplied)/(% Change in Price) (% Change in Quantity Supplied) = [[QSupply(NEW) - QSupply(OLD)] / [QSupply(OLD) + QSupply(NEW)]] *2] (% Change in Price) = [[Price(NEW) - Price(OLD)] / [Price(OLD) + Price(NEW)]] *2] New Formulas - Arc Income Elasticity of Demand To calculate the Arc Income Elasticity of Demand, we use the formulas: 6|Page

PEoD = (% Change in Quantity Demanded)/(% Change in Income) (% Change in Quantity Demanded) = [[QDemand(NEW) - QDemand(OLD)] / [QDemand(OLD) + QDemand(NEW)]] *2] (% Change in Income) = [[Income(NEW) - Income(OLD)] / [Income(OLD) + Income(NEW)]] *2] New Formulas - Arc Cross-Price Elasticity of Demand of Good X To calculate the Arc Cross-Price Elasticity of Demand, we use the formulas: PEoD = (% Change in Quantity Demanded of X)/(% Change in Price of Y) (% Change in Quantity Demanded) = [[QDemand(NEW) - QDemand(OLD)] / [QDemand(OLD) + QDemand(NEW)]] *2] (% Change in Price) = [[Price(NEW) - Price(OLD)] / [Price(OLD) + Price(NEW)]] *2] Notes and Conclusion Keep in mind that for all over these formulas it doesn't matter what you use as the "old" and as the "new" value, just as long as the "old" price is the one associated with the "old" quantity. You could call the points A and B or 1 and 2 if you like, but old and new works just as well. So now you can calculate elasticity using a simple formula as well as using the arc formula. In a future article, we will look at using calculus to compute elasticities.

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Using Calculus To Calculate Price (Point) Elasticity of Demand

Suppose you're given the following question: Demand is Q = 110 - 4P. What is price (point) elasticity at $5? We saw that we can calculate any elasticity by the formula: Elasticity of Z with respect to Y = (dZ / dY)*(Y/Z) In the case of price elasticity of demand, we are interested in the elasticity of quantity demand with respect to price. Thus we can use the following equation: Price elasticity of demand: = (dQ / dP)*(P/Q) In order to use this equation, we must have quantity alone on the left-hand side, and the righthand side be some function of price. That is the case in our demand equation of Q = 110 - 4P. Thus we differentiate with respect to P and get: dQ/dP = -4 So we substitute dQ/dP = -4 and Q = 110 - 4P into our price elasticity of demand equation: Price elasticity of demand: = (dQ / dP)*(P/Q) Price elasticity of demand: = (-4)*(P/(110-4P) Price elasticity of demand: = -4P/(110-4P) We're interested in finding what the price elasticity is at P = 5, so we substitute this into our price elasticity of demand equation: Price elasticity of demand: = -4P/(110-4P) Price elasticity of demand: = -20/90 Price elasticity of demand: = -2/9 Thus our price elasticity of demand is -2/9. Since it is less than 1 in absolute terms, we say that Demand is Price Inelastic

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