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Qd always responds positively to the
change in income.
Less Elastic
Y
More Elastic
O
Qd
Recap
∆ Y in PQ space
P
Elastic D
D``
D``
Inelastic D
D`
D`
D
Q
Example
Income (Rs)
Quantity Demanded
(units)
10000
100
12000
105
YЄd = ∆ Q ÷ ∆ Y
Q
Y
= 5 ÷ 2000
100
10000
= 0.25
Rule: If sign is positive the good
is normal and if sign is negative
the good is inferior.
The Good is normal (the sign is positive). But its demand is income
inelastic o< | Є | < 1.
Determinants of income elasticity of
demand
1. Degree of necessity of good.
2. The rate at which the desire for good is satisfied as
consumption increases
3. The level of income of consumer.
Food Stuff
YЄd
Milk
-0.40
Eggs
-0.41
Mutton
-0.21
Bread
-0.25
Butter
-0.04
MargarIne
-0.44
Sugar
-0.54
Fresh Potatoes
-0.48
Tea
-0.56
Cheese
0.19
Beef
0.08
Cakes&Buiscuits
0.02
Fresh Green Vegetables
0.13
Fresh Fruit
0.48
Fresh Juices
0.94
Coffee
0.23
ElasticIty For All Food
-0.01
Cross price elasticity of demand
It is defined as the percentage change in quantity demanded of
good A divided by the percentage change in the price of
another related good B.
Example
Demand for A
Price of B
100
10
140
12
PbЄda = ∆ Qa ÷
Qa
= 40 ÷ 2
100
10
= 2
∆ Pb
Pb
If a sign is positive the
goods are substitutes and if a sign
is negative the goods are
complements
Rule:
Goods are substitutes ( sign is positive ) Demand is
cross price elastic | є | > 1.
Example 2
•A Government will wish to know how a change in
domestic prices will affect the demand for imports.
•Rise in price of imports worsening the Balance of
payments
Adjusting to oil price shocks
SHORT RUN
P
S2
S1
B
P2
A
P1
D1
O
Q2
Q1
Q
Adjusting to oil price shocks
Long Run effect on demand
P
S2
S1
B
P2
P1
C
A
DL
D1
D2
O
Q
Adjusting to oil price shocks
Long Run effect on supply
P
S2
S1
B
P2
P1
S3
E
SL
F
D
D1
O
Q
Incidence of tax when the demand is
inelastic
• Fixed Tax
P
S2
C
P1
D
D
P0
X
S1
T
A
X
B
A
D
Q1
Q0
Q
Incidence of tax when the demand is
elastic
• Fixed Tax
S1
P
C`
P1
X`
S0
B`
D`
P0
O
T
A
X
D
A`
Q1
Q0
Q
Inelastic demand
• Case 1
S + Tax
P
T
A
X
P2
S1
P1
D
O
Q2
Q1
Q
Elastic demand
• Case 2
S + Tax
P
T
A
X
P2
S1
P1
D
O
Q2
Q1
Q
Inelastic supply
• Case 3
S + Tax
P
S
T
A
X
P2
P1
D
O
Q2
Q1
Q
Elastic supply
• Case 4
P
S + Tax
T
A
X
P2
S
P1
D
O
Q2
Q1
Q
Tax on smoking
• Case 1
S + Tax
P
T
A
X
P2
S1
P1
D
O
Q2
Q1
Q
Tax on environmental pollution
• Case 3
S + Tax
S
P
T
A
X
P2
P1
D
O
Q2
Q1
Q
Summary
3 Core rules of elasticity
RULE # 1:
Inelastic
Less than
RULE # 2:
Income elasticity
RULE # 3:
Cross elasticity
Greater than
1
Elastic
+
Normal good
–
Inferior good
+
Substitutes
–
Complements