Elasticity of Demand

CFA Level 1 - Microeconomics

Determinants of price elasticity include:

• Availability of substitutes - if substitutes are plentiful, then demand should be elastic.
• Relative percentage of expenditure - if an item takes up a considerable proportion of a consumer's income, then demand should be elastic; if it takes up a very small amount, then demand should be expected to be inelastic.
• Amount of time - consumers can make more adjustments to prices changes over time and, therefore, demand tends to be more elastic as time passes.
• Necessities or luxuries - demand for necessities will tend to be inelastic, while demand for luxuries will tend to be elastic.

Cross Elasticity of Demand

Cross elasticity of demand relates the percentage change in quantity demanded of a good to the percentage change in price of a substitute or complementary good. Examples of complementary goods would include peanut butter and jelly, and large SUVs and gasoline.

 The cross elasticity of demand will be positive for a substitute, and negative for a complement; i.e. demand for a substitute (complement) will go up (down), if the price of the substitute (complement) goes up.

The following formula can be used to calculate cross-elasticity of demand:

 

Formula 3.2 Where:  CEp is the cross-price elasticity coefficient, %ΔQ represents the percentage change in quantity demanded, and %ΔP represents the percentage change in price of the substitute or complement.

Income Elasticity

Income Elasticity is defined as the percentage change in quantity demanded divided by the percentage change in income.  The calculations are similar to those for price elasticity, except that the denominator would include a change in income instead of a change in price.

Usually the amount of goods purchased will be positively correlated with income; if consumers' incomes go up (down), more (less) goods will be purchased. Any good with a positive income of elasticity of demand is said to be a normal good. Luxury goods have high income elasticity (greater than one). The proportionate amount of spending for those goods will go up as incomes increase.

The amount spent on some goods decrease as incomes goes up. Such goods are referred to as inferior goods. Examples of inferior goods include margarine (inferior to butter) and bus travel (inferior to owning a vehicle).

(See more) Elasticity of Supply

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