Elasticity

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Income Elasticity of Demand

Definition: Measures the responsiveness of quantity demanded to changes in income.

Formula:

Normal Goods ® Positive YED
As income rise people tend to buy more of these goods.

Luxury Goods ® Positive YED > 1
As income rises the demand rises by a greater proportion (hi-fi goods).

Necessities ® Positive YED < 1
As income rises the demand rises by a smaller proportion, e.g. Milk

Inferior Goods ® Negative PED
As income rises the demand for the good falls. (Own brand goods in shops)

Examples

GOOD A: YED = +3.0
This good is a luxury good because a 10% increase in income will cause a 30% increase in the demand for the good.

GOOD B: YED = +0.5
This is a normal necessity because a 10% increase in income will cause only a 5% increase in the demand for the good.

GOOD C: YED = -2.5
This is an inferior good because a 10% increase in income will cause a 25% decrease in the demand for the good.

Cross Elasticity of Demand

Definition: Measures the proportionate change in one good when the price of another good changes.

Formula:

Examples:

Complementary Goods ® CED is Negative
If the price of one good rise (gin) then the demand for it's complement falls (tonic water). The more complementary the goods, the higher will be the negative CED.

Substitute Goods ® CED is Positive
If the price of one good rises (tea) then the demand for it's substitute also rises and vice-versa. The closer the substitutes, the higher will be the positive CED.

Non-related Goods ® CED is Zero
These goods are not related, so a rise in the price of one good will have no effect on the demand for the other good.

Question
CED between Good A and Good B = +2.3
CED between Good A and Good C = +0.4
CED between Good A and Good D = -0.7
CED between Good A and Good E = -1.5
Which of these goods are complements to Good A?
Which of these goods is the closest substitute to Good A?
Solution
Good D and E are complements to Good A because they have a negative CED.
Good B and C are substitutes to good A because they have a positive CED, but Good B is the closest substitute because it has the highest value.

Price Elasticity of Supply

Definition: Measures the responsiveness of quantity supplied to changes in price.

Formula:

Note: PES is usually positive because an increase in price will cause more to be supplied and vice-versa.
If PES > 1, the good is elastic (responsive to changes in price).
If PES < 1, the good is inelastic (not very responsive to changes in price).

Past Questions on Elasticity

1999 Q4: CED and definitions
1998 Q2: CED, YED, PED
1997: None
1996 Q1: YED
1995 Q1: PED
1994 Q1: CED, YED, PED
1993 Q1: PED and definitions.

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