Income Elasticity of Demand

and Cross Price Elasticity of

Demand

1
 Objectives

 Define the income elasticity of demand and how to

calculate it.

 Define the cross-price elasticity of and how to

calculate it.

2
 Objective 1
Define the income elasticity of demand
and understand how to calculate it.

 The income elasticity of demand (εI ) measures

the responsiveness of quantity demanded to
changes in consumer income.

3
Objective 1….the income elasticity of demand
 An example will help demonstrate what it is that the income
elasticity measures. The graph shows what happens to Janet’s
demand for coffee when her income changes.

Example 1: At point “c”, the

price of coffee is $3.00, Janet’s
income is $500/week and
Janet’s quantity demanded is 5
cups.
When her income rises to
$700/week, her demand curve
shifts right. She is now willing
to buy 8 cups, at the same price.
This is given by point “w” on
the new demand curve D1.

4
Objective 1….the income elasticity of demand
 Note: the price of coffee does not change; income changes
and Janet responds to the income change by buying more
coffee.

 Income elasticity is concerned precisely with this: the change

from “c” on one demand curve to “w” on another demand
curve, holding price constant.

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Objective 1….the income elasticity of demand

 In Example 1, Janet’s quantity demanded increases

when her income increases.
increases
 To Janet coffee is a normal good.
 The income elasticity coefficient for a normal good is
positive.

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Objective 1….the income elasticity of demand
Example 2: Consider Daria’s demand for coffee.
At point “c”, the price of coffee is $3.00, Daria’s income is
$500/week and Daria’s quantity demanded is 5 cups.
When her income rises to $700/week, she buys less at the
same price of coffee. Her quantity demanded has now falls
to 3 cups, corresponding to point “x” on the new demand
curve D1.

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Objective 1….the income elasticity of demand
 Daria’s quantity demanded decreases when her income
increases.
 To Daria coffee is an inferior good.
 The income elasticity coefficient for an inferior good is
negative.

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Objective 1….the income elasticity of demand

 The formula for the income elasticity of demand is:

%ΔQuantity Demanded
Income Elasticity of Demand =
%ΔIncome

 If the income elasticity of demand (εI) is positive, εI > 0  the

good is a normal good.
good

negative εI < 0  the

 If the income elasticity of demand (εI) is negative,
good is an inferior good.

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Objective 1….calculating the income elasticity of
demand
Example 3: Suppose quantity demanded increases by 4% when
income rises by 5%. What is the income elasticity of demand for
this good? Indicate if the good is normal or inferior.

Solving the Problem

 Apply the elasticity formula:

%ΔQuantity Demanded
Income Elasticity of Demand =
%ΔIncome
4
=
5
= 0.8

 Since the income elasticity is a positive number, the good is a

normal good.

10
10
Objective 1….calculating the income elasticity of
demand
 The income elasticity coefficient = 0.8. What does the
number 0.8 mean?
 Let’s go back to the elasticity formula and rearrange the
equation by cross multiplying.

 The income elasticity formula can be rewritten as:

%∆Quantity Demanded = 0.8 × %∆Income

 For every 1% increase in income, quantity demanded

increases by 0.8% or for every 10% increase in income,
quantity demanded increases by 8%.

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Objective 1….calculating the income elasticity
of demand

Example 4: Suppose when income rises by 10%, quantity

demanded decreases by 6%. Calculate the income elasticity of
demand for this good. Indicate if the good is normal or inferior.
Solving the Problem
 Apply the elasticity formula:

%ΔQuantity Demanded
Income Elasticity of Demand =
%ΔIncome
6
=
10
= 0.6

 The negative coefficient indicates that the good is an

inferior good.
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Objective 1….calculating the income elasticity of
demand
Example 5: Suppose at an income level of $30,000, Francesca buys 2
units of good X per month. When her income rises to $50,000, she
buys 5 units per month. Calculate the income elasticity of demand
for good X and indicate if the good is inferior or normal.

 Solving the Problem

Essentially, you are given two

sets of income-quantity
combinations:
“a”: Income0= $30,000, Q0 = 2 and
“b”: Income1 = $50,000; Q1 = 5.

Apply these values to the midpoint

formula.

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Objective 1….the average method of calculating the
income elasticity of demand
%ΔQuantity
Income Elasticity of Demand =
%ΔIncome
ΔQuantity
× 100
½(Q0 + Q1 )
=
ΔIncome
× 100
½(I0 + I1 )

Simplify by cancelling the ½ s and the 100s to give:

ΔQuantity ΔIncome
Income Elasticity of Demand = ÷
(Q0 + Q1 ) (I0 + I1 )
(Q0 - Q1 ) (I0 - I1 )
= 
(Q0 + Q1 ) (I0 + I1 )
Q0 - Q1 I0 + I1
= ×
Q0 + Q1 I0 - I1

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Objective 1….the average method of calculating the
income elasticity of demand

 Now plug in the given values:

Q0 - Q1 I0 + I1
Income Elasticity of Demand = ×
Q0 + Q1 I0 - I1
2 - 5 30,000 + 50,000
= ×
2 + 5 30,000 - 50,000
-3 80,000
= ×
7 -20,000
3 8
= ×
7 2
= 1.71

 The income elasticity is positive. Therefore, good X is a

normal good.

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Objective 1: …describing income elasticities

 If the income elasticity of demand > 1  demand is

income elastic.
 If the income elasticity of demand < 1  demand is
Income inelastic.
 If the income elasticity of demand = 1  demand is
unit income elastic.

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Objective 1: …describing income elasticities

 Since inferior goods have a negative income elasticity (<0)

which also means a number < 1, inferior goods are income
inelastic ALWAYS.

 Normal goods may be income elastic or income inelastic.

Necessities are normal goods that are income inelastic.

The income elasticity is a positive number less than 1.
1

Luxury goods are normal goods that are income elastic

The income elasticity is a positive number greater than 1.

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Objective 1: Income elasticity – a summary

Income elasticity of demand > 1 Normal, luxury good Income elastic

Income elasticity of demand is

Normal, necessity Income inelastic
a positive number less than 1.

Income elasticity = 1 Normal Unit income elastic

Income elasticity of demand is a

a negative number. Inferior good Income inelastic

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Objective 1: Income elasticity – a summary

 The income elasticity of demand tells us how quantity

demanded responds to changes in income.
 The income elasticity of demand is used to determine if
a good is an inferior good or a normal good and, if it is
a normal good, whether it is it luxury good or a
necessity.
necessity

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 Objective 2
Define the cross-price elasticity of demand ….

The cross price elasticity of demand (CPE) measures the

responsiveness of quantity demanded to changes in the price of
a substitute good or a complementary good, holding all else
constant.

For example, if the price of coke changes, how does this affect
the quantity demanded of Pepsi, holding the price of Pepsi
constant?

Or, if the price of bagels changes, how does this affect the
quantity demanded of cream cheese, holding the price of cream
cheese constant?

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Objective 2….the cross-price elasticity of demand

 An example will help demonstrate what it is that the

cross-price elasticity measures.

Example 1: Consider two goods, good X and good Y.

Suppose the price of good X rises from $6 to $7.

 The increase is the price of good X is demonstrated by

a movement along the demand curve for good X.

When price rises,

there is a
movement along
the curve

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Objective 2….the cross-price elasticity of demand

 As a result of the increase in the price of good X,

X the
demand for good Y increases.
increases

 At a given price of good Y, the quantity demanded

increases from Qe to Qf.

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Objective 2….the cross-price elasticity of demand

 Note: the price of good Y does not change; the price of

good X has changed and the consumer responds to this
change by buying more of good Y.

 Cross price elasticity elasticity is concerned precisely

with this: the change in the price in market X and its effect on
the quantity demanded in market Y. In market Y quantity
demanded has changed from “e” on one demand curve to “f”
on another demand curve, holding the price of good Y
constant.
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Objective 2….the cross-price elasticity of demand

 In my example, the increase in the price of good X

causes an increase in the quantity demanded of good Y.
Y

 there is a positive relationship between the change in

the price of X and the change in the quantity
demanded of Y.
 X and Y are substitute goods.
24
Objective 2….understanding the cross-price elasticity of
demand

Example: the cross price elasticity between the price of

Coke and the quantity demanded of Pepsi.

Suppose Price of Coke ↑

 Demand for Pepsi increases (shifts right).

At a given price of Pepsi, quantity demanded of
Pepsi increases.

 positive relationship between the price of Coke and

the quantity demanded of Pepsi.

 Coke and Pepsi are substitutes.

25
Objective 2….the cross-price elasticity of demand

Example 2: Consider two goods, good A and good B.

Suppose the price of good A rises from $5 to $6.

 The increase is the price of good A is demonstrated by

a movement along the demand curve for good A.

When price rises,

there is a
movement along
the curve

26
Objective 2….the cross-price elasticity of demand

 As a result of the increase in the price of good A,

A the
demand for good B decreases.
decreases

 At a given price of good Y, the quantity demanded

decreases from Qg to Qh.

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Objective 2….the cross-price elasticity of demand
 In this example, the increase in the price of good A causes
a decrease in the quantity demanded of good B. B

 there is a negative relationship between the change in

the price of good A and the change in the quantity
demanded of good B.
 A and B are complementary goods.

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Objective 2….understanding the cross-price elasticity of
demand

Example: the cross price elasticity between the price of

donuts and the quantity demanded of coffee.

Suppose Price of donuts ↑

 demand for coffee decreases (shifts left). At a given

price of coffee, quantity demanded of coffee decreases.

 negative relationship between the price of donuts and

the quantity demanded of coffee.

 donuts and coffee are complements.

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Objective 2…. the cross-price elasticity of demand

 Let CPEXY denote the cross price elasticity of demand

between good X and good Y.
 The formula for the cross price elasticity of demand is:

%ΔQuantity Demanded of Good Y

CPEXY =
%ΔPrice of Good X

 If the cross price elasticity of demand is positive,

CPEXY > 0  X and Y are substitutes.

 If the cross price elasticity of demand is negative,

negative
CPEXY < 0  X and Y are complements.

30
Objective 2: calculating the cross-price elasticity
of demand

Example 3: Suppose a 6 percent decrease in the price of

ibuprofen causes a 10 percent decrease in the quantity
demanded of Tylenol. What is the cross price elasticity of
demand for Ibuprofen with respect to the price of Tylenol?
Are the two goods complements or substitutes?

31
Objective 2: calculating the cross-price elasticity
of demand
Example 3: Suppose a 6 percent decrease in the price of ibuprofen causes
a 10 percent decrease in the quantity demanded of Tylenol. What is the
cross price elasticity of demand for Ibuprofen with respect to the price of
Tylenol? Are the two goods complements or substitutes?

 Solving the Problem

Apply the formula:
%ΔQuantity Demanded of Tylenol
CPE =
%ΔPrice of Ibuprofen
-10
=
-6
= 1.67

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Objective 2: calculating the cross-price elasticity
of demand
Example 3: Suppose a 6 percent decrease in the price of ibuprofen
causes a 10 percent decrease in the quantity demanded of Tylenol.
What is the cross price elasticity of demand for Ibuprofen with
respect to the price of Tylenol? Are the two goods complements or
substitutes?
 Solving the Problem
Apply the formula:

%ΔQuantity Demanded of Tylenol

CPE =
%ΔPrice of Ibuprofen
-10
=
-6
= 1.67

 The coefficient is positive which indicates that Tylenol

and Ibuprofen are substitutes.

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Objective 2: understanding the cross-price elasticity of
demand

How do we interpret the number 1.67≈ 1.7?

The cross price elasticity formula can be rewritten as

follows:

%∆Quantity Demanded of Tylenol = 1.7 x %∆ Price of Ibuprofen

 For every 1% decrease in the price of ibuprofen, the

quantity demanded of Tylenol falls by 1.7% or, for every
for every 10% increase in the price of ibuprofen, the
quantity demanded of Tylenol rises by 17%.

34
Objective 2: calculating the cross-price
elasticity of demand

Example 4: In the graph, the demand for tortilla chips has

shifted outward because the price of salsa has fallen from
$3.20 to $2.80 per package. Calculate the cross-price
elasticity of demand between tortilla chips and salsa.
What is the relationship between these two goods?

35
Objective 2: calculating cross-price elasticity

 Solving the problem:

To calculate the cross-price elasticity of demand
between tortilla chips and salsa, we have to calculate
(1) the percentage change in the quantity demanded of
tortilla chips
(2) the percentage change in the price of salsa
(3) apply the average or midpoint method of calculating
elasticities

36
Objective 2: calculating cross-price elasticity
 Solving the problem:
To calculate the cross-price elasticity of demand
between tortilla chips and salsa, we have to calculate
(1) the percentage change in the quantity demanded of
tortilla chips
(2) the percentage change in the price of salsa
(3) apply the average or midpoint method of calculating
elasticities

The percentage change in the

quantity demanded of tortilla
chips

The percentage
change in the price
of salsa

37
Objective 2: calculating cross-price elasticity
 Solving the problem:
To calculate the cross-price elasticity of demand
between tortilla chips and salsa, we have to calculate
(1) the percentage change in the quantity demanded of
tortilla chips
(2) the percentage change in the price of salsa
(3) apply the average or midpoint method of calculating
elasticities

The percentage change in the

quantity demanded of tortilla
chips

The percentage
change in the price
of salsa

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The average method of calculating cross price elasticity:

%ΔQuantity Demanded of Tortilla Chips

Cross Price Elasticity =
%ΔPrice of Salsa
ΔQuantity Demanded of Tortilla Chips
× 100
½(Qc + Qa )
=
ΔPrice of Salsa
× 100
½(P0 + P1 )

ΔQuantity Demanded of Tortilla Chips

(Qc + Qa )
=
ΔPrice of Salsa
(P0 + P1 )

2, 000 -0.4
= ÷
24, 000 6

1 6
=- ×
12 0.4

= -1.25

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The average method of calculating cross price elasticity:

%ΔQuantity Demanded of Tortilla Chips

Cross Price Elasticity =
%ΔPrice of Salsa
ΔQuantity Demanded of Tortilla Chips
× 100
½(Qc + Qa )
=
ΔPrice of Salsa
× 100
½(P0 + P1 )

ΔQuantity Demanded of Tortilla Chips

(Qc + Qa )
=
ΔPrice of Salsa
(P0 + P1 )

2, 000 -0.4
= ÷
24, 000 6

1 6
=- ×
12 0.4

= -1.25

 The negative coefficient indicates that the two goods are

complements.
complements
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Objective 1: Cross Price elasticity – a summary

 The cross price elasticity of demand between good X

and good Y tells us how quantity demand of good Y
responds to a change in the price of good X

41
Objective 1: Cross Price elasticity – a summary

 The cross price elasticity of demand between good X

and good Y tells us how quantity demand of good Y
responds to a change in the price of good X

 The important thing to note is that we are looking at

price changes in one market and quantity changes in
another market.

42
Objective 1: Cross Price elasticity – a summary

 The cross price elasticity of demand between good X

and good Y tells us how quantity demand of good Y
responds to a change in the price of good X

 The important thing to note is that we are looking at

price changes in one market and quantity changes in
another market.

 The sign of cross price elasticity of demand coefficient

indicates if the two goods are substitutes or
complements.

43
Objective 1: Cross Price elasticity – a summary

Cross price elasticity of demand between

X and Y are substitutes
X and Y is a positive number.
Cross price elasticity of demand between
X and Y are complements
X and Y is a negative number.
Cross price elasticity of demand between
X and Y are unrelated
X and Y is zero.

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