qd always responds positively to the change in income

Qd always responds positively to the change in income.

QdO

Y

More Elastic

Less Elastic

Recap

D

D`

Q

P

Inelastic D D`

Elastic D D``

∆ Y in PQ space

D``

Example

Income (Rs)Quantity Demanded

(units)

10000 100

12000 105

YЄd = ∆ Q ÷ ∆ Y Q Y = 5 ÷ 2000 100 10000 = 0.25

The Good is normal (the sign is positive). But its demand is income inelastic o< | Є | < 1.

Rule: If sign is positive the good is normal and if sign is negative the good is inferior.

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

M i l k -0.40

E g g s -0.41

M u t t o n -0.21

B r e a d -0.25

B u t t e r -0.04

M a r g a r I n e -0.44

S u g a r -0.54

F r e s h P o t a t o e s -0.48

T e a -0.56

C h e e s e 0.19

B e e f 0.08

C a k e s & B u i s c u i t s 0.02

F r e s h G r e e n V e g e t a b l e s 0.13

F r e s h F r u i t 0.48

F r e s h J u i c e s 0.94

C o f f e e 0.23

E l a s t i c I t y F o r A l l F o o d -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 ÷ ∆ Pb

Q a Pb = 40 ÷ 2 100 10 = 2

Goods are substitutes ( sign is positive ) Demand is cross price elastic | є | > 1.

Rule: If a sign is positive the goods are substitutes and if a sign is negative the goods are complements

Example 2

•A Government will wish to know how a change in A Government will wish to know how a change in

domestic prices will affect the demand for imports. domestic prices will affect the demand for imports.

•Rise in price of imports worsening the Balance of Rise in price of imports worsening the Balance of

payments payments

Adjusting to oil price shocks

SHORT RUNSHORT RUN

P

A

P1

Q

P2

Q1Q2

S1

S2

B

D1

O

Adjusting to oil price shocks

Long Run Long Run effect on demandeffect on demand

P

A

P1

Q

P2

S1

S2

B

D1

D2

C DL

O

Adjusting to oil price shocks

P

DP1

Q

P2

S1

S2

Long Run Long Run effect on supplyeffect on supply

D1

B

S3

FE

SL

O

Incidence of tax when the demand is inelastic

• Fixed TaxFixed Tax

P

BP0

Q

P1

Q0Q1

S1

S2

C TAX

D

A

D

X

D

Incidence of tax when the demand is elastic

• Fixed TaxFixed Tax

P

B`P0

Q

P1

Q0Q1

S0

S1

C`

A`

O

X`

D`

D

TAX

Inelastic demand

• Case 1Case 1

P

P1

Q

P2

Q1Q2

S1

S + Tax

O

D

TAX

Elastic demand

• Case 2Case 2

P

P1

Q

P2

Q1Q2

S1

S + Tax

O

D

TAX

Inelastic supply

• Case 3Case 3

P

P1

Q

P2

Q1Q2

SS + Tax

O

D

TAX

Elastic supply

• Case 4Case 4

P

P1

Q

P2

Q1Q2

S

S + Tax

O

D

TAX

Tax on smoking

• Case 1Case 1

P

P1

Q

P2

Q1Q2

S1

S + Tax

O

D

TAX

Tax on environmental pollution

• Case 3Case 3

P

P1

Q

P2

Q1Q2

SS + Tax

O

D

TAX

3 Core rules of elasticity3 Core rules of elasticity

RULE # 1:

1Less than Greater thanInelasticInelastic ElasticElastic

RULE # 2:

Income elasticity+

–

Normal good

Inferior good

RULE # 3:

Cross elasticity –

Complements

+ Substitutes

SummarySummary