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Income Elasticity (Normal Goods) Income Elasticity (Normal Goods) Income Elasticity [normal goods] ey % D Qx % DY Income elasticity is a measure of the change in demand [a “shift” of the demand function] that is “caused” by a change in income. [Where Y = income] The increase in income, DY, increases demand to D2. The increase in demand results in a larger quantity being purchased at the same Price [P1].. At a price of P1 , the quantity demanded P given the demand D is Q1 . D is the demand function when the income is Y1 . For a “normal good” an increase in income to Y2 will “shift” the demand to the right. This is an increase in demand to D2. Due to increase in income, demand increases P1 D2 D % D Y > 0; % D Q> 0; therefore, ey >0 [it is positive] Q1 . Q2 Q/ut % D Qx ey %DY A decrease in income is associated with a decrease in the demand for a normal good. At income Y1, the demand D1 represents the relationship between P and Q. At a price [P1] the quantity [Q1] is demanded. % DY < 0 [negative]; so, ep > 0 [ positive] P For a decrease in income [-D Y], the demand decreases; i.e. shifts to the left, at the price [P1 ], a smaller Q2 will be purchased. A decrease in income, % DQ < 0 [negative]; P1 decreases demand For either an increase or decrease in income the ep is positive. A positive relationship [positive correlation] between D Y and D Q is evidence of a normal good. D2 Q2 Q1 D1 Q/ut When income elasticity is positive, the good is considered a “normal good.” An increase in income is correlated with an increase in the demand function. A decrease in income is associated with a decrease in the demand function. For both increases The greater the value of ey, the more responsive buyers + are to a change in their incomes. eeyy and decreases in income, ey is positive DxxQx %%D% +DQ Q %DY +- %%D YD Y When the value of ey is greater than 1, it is called a “superior good.” The |% D Qx| is greater than the |% D Y|. Buyers are very responsive to changes in income. Sometimes “superior goods” are called “luxury goods.” . . ey % D Qx %DY Income Elasticity (Normal Goods) Income Elasticity (Inferior Goods) There is another classification of goods where changes in income shift the demand function in the “opposite” direction. An increase in income [+DY] reduces demand. An increase in income reduces the amount that individuals are willing to buy at each price of the good. Income elasticity is negative: - ey The greater the absolute value of - ey, the more responsive buyers are to changes in income eyy = -e P P1 . x x %+DY DY decreases demand - %DQ x Q2 . -%%DQ DQ Q1 D2 D1 Q/ut Decreases in income increase the demand for inferior goods. A decrease in income [-DY] increases demand. A decrease in income [-D Y] results in an increase in demand, the income elasticity of demand is negative For both increases and decreases in income the income elasticity is negative for inferior goods. The greater the absolute value of ey, the more responsive buyers are to changes in income . . P +%DQ % D Q xx - eey y %DY -DY P1 D2 +%DQ D1 x Q1 Q2 Q/ut Income Elasticity Income elasticity [ey] is a measure of the effect of an income change on demand. [Can be calculated as point or arc.] ey > 0, [positive] is a normal or superior good an increase in income increases demand, a decrease in income decreases demand. 0 < ey < 1 is a normal good 1 < ey is a superior good ey < 0, [negative] is an inferior good Fall '97 Economics 205Principles of Microeconomics Slide 8 Examples of normal goods, [0 < ey < 1 ], (between 0 and 1) coffee, beef, Coca-Cola, food, Physicians’ services, hamburgers, . . . Superior goods, [ ey > 1], (greater than 1) movie tickets, foreign travel, wine, new cars, . . . Inferior goods, [ey < 0], ey (negative) flour, lard, beans, rolled oats, . . . Fall '97 Economics 205Principles of Microeconomics Slide 9 Income Elasticity (Normal Goods) Cross-price elasticity of demand, [exy] [substitutes] Pm 2 1.50 -DQp Qm’ Qm . When beef is $2, Qb beef Pb is purchased. at Pb = $2 more increase beef will be bought demand to substitute for the smaller 2 quantity of for an increase mutton. in Pmutton, demand for Db Db Dp beef increases When mutton is $1.50, Qm is purchased. price of mutton increases The quantity demanded of mutton decreases. [price of beef] [price of mutton] When the price of mutton increases, it will tend to increase the demand for beef. People will substitute beef, which is relatively cheaper, for mutton, which is relatively more expensive. ’ mutton/ut Qb Qb’ beef/ut Cross-price elasticity In the case of beef and mutton the ebm is not the same as emb ebm is the % change in the demand for beef with respect to a % change in the price of mutton emb is the % change in the demand for mutton with respect to a % change in the price of beef beef may not be a good substitute for mutton mutton may not be a good substitute for beef The cross elasticity of the demand for beef with respect to the price of mutton, +ebm ebp = positive ebeef-mutton or ebm can be calculated: +Q DQ %D ofb beef %DP+of DPmutton m cross elasticity is positive +eebmbp = positive Qbeef b %D -Q Dof %DP of mutton - DPm An increase in the price of mutton, “causes” an increase in the demand for beef. A decrease in the price of mutton, “causes” a decrease in the demand for beef. If goods are substitutes, exy will be positive. The greater the coefficient, the more likely they are good substitutes. Income Elasticity (Normal Goods) Cross-price elasticity of demand, [exy] [Compliments] Pc P1 Po Pc a decrease in the price of crayons, -DPc Dp Q1 Q2 - ebc ebc = negative DQ %D+ Q ofbb - $3 crayons increases the quantity demanded of crayons %DP of c DPc increase demand as more crayons are purchased, the demand for colour books increases. At the same price a larger quantity will be bought Dc Dc’ 2000 2500 + DQb colour books for compliments, the cross elasticity is negative for price increase or decrease. Cross-Price Elasticity exy > 0 [positive], suggests substitutes, the higher the coefficient the better the substitute exy < 0 [negative], suggests the goods are compliments, the greater the absolute value the more complimentary the goods are exy = 0, suggests the goods are not related Fall '97 Economics 205Principles of Microeconomics Slide 16 Income Elasticity (Normal Goods) Elasticity of Supply Elasticity of Supply Elasticity of supply is a measure of how responsive sellers are to changes in the price of the good. Elasticity of supply [ep] is defined: e s Fall '97 % D Quantity Supplied % D price Economics 205Principles of Microeconomics Slide 18 es = %DQsupplied %DP Given a supply function, at a price [P1], Q1 is produced and offered for sale. P At a higher price [P2], a larger quantity, Q2, will be produced and offered for sale. P2 P1 The increase in price [ DP ], induces a larger quantity goods [ DQ]for sale. +DP The more responsive sellers are to +DQ Q1 Q2 DP, the greater the absolute value of Q /ut es. [The supply function is “flatter”or more elastic] The supply function is a model of sellers behavior. P Si a perfectly inelastic supply, es = 0 Sellers behavior is influenced by: 1. technology 2. prices of inputs 3. time for adjustment market period short run long run very long run 4. expectations 5. anything that influences costs of production taxes regulations, . . . Se a perfectly elastic supply [es is undefined.] Q /ut Summary Income Elasticity (Normal Goods) Price elasticity of demand [measures a move on a demand function caused by change in price/arc or point] elastic, inelastic or unitary elasticity income elasticity [measures a shift of a demand function associated with a change in income] superior, normal, and inferior cross elasticity measure the shift of a demand function for a good associated with the change in the price of a related good [compliment/substitute] price elasticity of supply [measures move on a supply curve] Reference: Principles of Economics, 6/e by Karl Cas, Income Elasticity Ray Fair (Normal Goods) Slides prepared by: Fernando Quijano and Yvonn Quijano