ELA - Income and Cross Price Elasticity Lesson

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Income and Cross Price Elasticity Lesson

While price has major influence over the quantities people wish to purchase of a good or service, there are two other major categories of changes that can significantly influence the amount of a good people wish to consume. These two categories are related to the "determinants" of demand mentioned in the previous module. That is, they are shifters of the demand curve.

Income Elasticity

Income elasticity (EI) is a measure of how responsive the demand of a good is to a change in consumer income. The formula for finding income elasticity is very similar to the formula for finding price elasticity. However, there are some differences.

EI equals {(percent delta D) divided by (percent delta I)} is equal to {[D2 minus D1 divided by (D2 plus D1) divided by 2] divided by [I2 minus I1 divided by (I2 plus I1) divided by 2.]}

It is similar to the previous formula in that it establishes a ratio. However, in this instance, the ratio is the change in demand for the good relative to the change in consumer income. Also, the absolute value is not taken when calculating income elasticity. As a matter of fact, the "sign" is extremely important in determining the nature of the good.  

Income Elasticity and the Nature of the Good

In regard to income, goods can be broken down into two major categories: inferior goods and normal goods. Goods are categorized as inferior or normal based on how consumer demand reacts when incomes change.

Inferior Goods: These are goods for which income and demand are negatively related. That is, if incomes increase, demand will decrease. Or, if incomes decrease, demand will increase. Because of this negative relationship, the value EI will be negative (less than 0).  

Normal Goods: These are goods for which income and demand are positively related. That is, if incomes increase, demand will increase. Or, if incomes decrease, demand will decrease. Because of this positive relationship, the value of EI will be positive. Normal Goods break down into two subcategories:

1. Normal Necessity - This is a good for which the value of EI is between 0 and 1.

2. Normal Luxury - This is a good for which the value of EI is greater than 1.  

So, the negative or positive sign determines the basic nature of the good. The numerical value illustrates the degree to which a good is considered inferior or luxury (for example, a good with an EI of -2 is more of an inferior good than one with an EI of -1.2).

Income Elasticity Summary

Income Summary Normal Goods: Goods for which changes in income and changes in demand for the good are positively related. Inferior Goods: Goods for which changes in income and changes in demand for the good are negatively related. Suppose Consumer Income Decreases: The demand for Green Giant canned vegetables will decrease. Income decreases; demand decreases The demand for Great Value canned vegetables will increase. Income decreases; demand increases

Summary of Scale for EI:

Value of EI

Type of Good

EI > 0

The good is a normal good.

0 < EI <1

The good is a necessity.

EI > 1

The good is a luxury.

EI < 0

The good is an inferior good.

Example: Suppose it is noticed that when incomes rise the demand for bologna decreases while the demand for steak increases.   In this instance, it would be correct to identify bologna as an inferior good (income and demand are negatively related - they moved in opposite directions) and steak as a normal good (income and steak are positively related - they moved in the same direction).  

Income Elasticity Practice

Solve the problem. Click the 'Show Solution' button below to check your answer and read the explanation.

Cross Price Elasticity

Cross price elasticity (ECP) is a measure of the responsiveness of the demand for one good in relation to the change in price of a related good. The formula for finding cross price elasticity is very similar to the formula for finding price elasticity. However, there are some differences.

ECP equals {(percent delta Dy) divided by (percent delta Px)} is equal to {[Dy2 minus Dy1 divided by (Dy2 plus Dy1) divided by 2] divided by [Px2 minus Px 1 divided by (Px 2 plus Px 1) divided by 2.]}

It is similar to the previous formulas in that it establishes a ratio. However, in this instance, the ratio is the change in demand for Good Y in response to a change in the price of Good X. Also, the absolute value is not taken when calculating cross price elasticity. As a matter of fact, the "sign" is extremely important in determining the relationship between the goods.  

Cross Price Elasticity and the Relationship of Goods

In regard to how goods are related, there are only three real possibilities - substitutes, complements, and unrelated. Click and drag the slider to view the possibilities for how goods are related.

Summary of Scale for Cross Price Elasticity:

Value of ECP

Type of Good

ECP > 0

The goods are substitutes.

ECP < 0  

The goods are complements.

ECP = 0

The goods are unrelated.

Cross Price Practice

Solve the problem. Click the 'Show Solution' button below to check your answer and read the explanation.

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