Income, cross and supply elasticities

Last time

Before we start: last time, in Demand, supply and related goods, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Three more elasticities

Demand responds not only to a good's own price, but to income and to the prices of other goods. And supply responds to price too. This lesson covers income elasticity, cross elasticity and price elasticity of supply, and how firms use them.

Income elasticity of demand

YED is the percentage change in quantity demanded divided by the percentage change in income. If income rises 10 per cent and quantity demanded rises 15 per cent, YED is 1.5: a luxury, or income elastic, normal good. If quantity demanded falls 5 per cent, YED is minus 0.5: an inferior good.

YED values

YED tells us the type of good.

Why YED matters to firms

In a boom, firms selling luxuries, with high YED, see demand rise fastest. In a recession, with falling incomes, demand for luxuries falls most, while inferior goods sell more. So firms use YED to plan output and to spread risk across products with different YEDs.

Cross elasticity of demand

XED is the percentage change in quantity demanded of good A divided by the percentage change in the price of good B. Positive XED: substitutes. If B's price rises 20 per cent and demand for A rises 10 per cent, XED is plus 0.5. Negative XED: complements. If demand for A falls 8 per cent, XED is minus 0.4. Zero: unrelated goods.

Usefulness of XED

XED shows how closely a firm's product competes with rivals', so it can predict the effect of a rival's price change. It helps pricing of complements, such as printers and ink. But estimates may be out of date, and other factors change at the same time.

Price elasticity of supply

PES is the percentage change in quantity supplied divided by the percentage change in price. It is positive. Determinants: time, spare capacity, stocks, mobility of factors, and the production period. Supply is more elastic in the long run than the short run.

Which elasticity matters most?

For a firm reacting quickly to market changes, PES shows how fast it can respond to a price rise. But PED tells it how price changes affect revenue, and YED how a recession affects demand. The most useful measure depends on the firm's situation and the change it faces.

Signs and sizes

For YED and XED, the sign matters: it tells you the type of good or relationship. For PED and PES, the size matters: it tells you elastic or inelastic. Always state the sign, the size, and what they mean.

Mistakes that lose marks

Mistake one: forgetting the sign of XED and YED, which shows the type of good. Mistake two: calling all goods with positive YED luxuries. Between 0 and 1 is a necessity. Mistake three: mixing up which price goes in the XED formula. The fix: formula, sign, size, meaning.

The full-marks tip

The full-marks tip: write each formula, then interpret: sign for YED and XED, size for PED and PES. In evaluation, say which elasticity is most useful, and why it depends on the situation.

On one card

So, on one card: YED, XED and PES. Keep it for revision.