Cross Elasticities of Demand

University Degree Business and Administrative studies

Examining the Importance of Income and Cross Elasticities of Demand to Business Decision Making

For the purpose of Business Decision making, firms are interested in the responsiveness of demand to determinants such as the relationship between consumers’ income and the prices of substitutes and complimentary goods in comparison to their own products. If for example a firm is considering changing the price of a particular good, it is essential that the effect of the price change on the quantity demanded is assessed. There are many economic tools to measure this relationship, two of which will be the topic of discussion.

The Income Elasticity of Demand ()

Income Elasticity of demand is defined as the responsiveness of demand to a change in consumers’ income (Y).

The basic formula for calculating the coefficient of income elasticity is:

Percentage change in quantity demanded of good X

Percentage change in real consumers' income

Normal Goods

Normal goods have a positive income elasticity of demand so as income rise more is demanded at each price level. A distinction is made between normal necessities and normal luxuries (both have a positive coefficient of income elasticity).

Necessities have an income elasticity of demand of between 0 and +1. Demand rises with income, but less than proportionately. Often this is because there is a limited need to consume additional quantities of necessary goods as real living standards rise. Examples of this would be the demand for fresh vegetables, toothpaste and newspapers. Demand is not very sensitive at all to fluctuations in income in this sense, total market demand is relatively stable following changes in the wider economic (business) cycle.

Luxuries are said to have an income elasticity of demand > +1. (Demand rises more than proportionate to a change in income). Luxuries are items consumers can (and often do) manage to do without during periods of below average income and falling consumer confidence (slumps). When incomes are rising strongly and consumers have the confidence to purchase expensive items, so the demand for luxury goods will grow. Conversely in a recession or economic slowdown, these items of discretionary spending might be the first victims of decisions by consumers to restrain their spending and rebuild savings and household financial balance sheets.

Many luxury goods are also referred to as “positional goods”. These are products where the consumer derives satisfaction (and utility) not just from consuming the good or service itself, but also from being seen to be a consumer by others (i.e. as a status symbol).

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Inferior Goods
Inferior goods have a negative income elasticity of demand. Demand falls as income rises. In a recession the demand for inferior products might actually grow (depending on the severity of any change in income and also the absolute co-efficient of income elasticity of demand). For example imagine that the income elasticity of demand for cigarettes is -0.3, then, a 5% fall in the average real incomes of consumers might lead to a 1.5% fall in the total demand for cigarettes (Ceteris paribus; other things being equal).

Within a given market, the income elasticity of demand for various products can vary and of course the perception of a product must differ from consumer to consumer. The important market for overseas holidays is a great example to develop further in this respect.

What to some people is a necessity might be a luxury to others. For many products, the final income elasticity of demand might be close to zero, in other words there is a very weak link at best between fluctuations in income and spending decisions. In this case the “real income effect” arising from a fall in prices is likely to be relatively small. Most of the impact on demand following a change in price will be due to changes in the relative prices of substitute goods and services.

The income elasticity of demand for a product will also change over time – the vast majority of products have a finite life-cycle. Consumer perceptions of the value and desirability of a good or service will be influenced not just by their own experiences of consuming it (and the feedback from other purchasers) but also the appearance of new products onto the market. Consider the income elasticity of demand for flat-screen colour televisions as the market for plasma screens develops and the income elasticity of demand for TV services provided through satellite dishes set against the growing availability and falling cost (in nominal and real terms) and integrated digital televisions.

Cross Price Elasticity of Demand ()

Cross Price Elasticity of demand measures the responsiveness of demand for a product to a change in the price of other related products. Normally focus is placed on the relationship between changes in the prices of substitutes and complements.

The formula for cross price elasticity of demand

Cross Price Elasticity of Demand

= Percentage change in the demand for Good X

Percentage change in the price of Good Y

Show cross price elasticity of demand through diagrams

The main use of cross price elasticity concerns changes in the prices of substitutes and complement’s.

With substitute goods such as brands of cereal or washing powder, an increase in the price of one good will lead to an increase in demand for the rival product. Cross price elasticity will be positive. In recent years, (due to technology and the move of manufacturing from Western countries to Asia: cheaper production costs), the prices of new cars have been falling. This should increase the demand for new cars and reduce the demand for second hand cars and mass transport services such as bus travel (ceteris paribus).

With goods that are in complementary demand such as the demand for DVD players and DVD videos, when there is a fall in the price of DVD players we expect to see more DVD players bought, leading to an expansion in market demand for DVD videos

When there is no relationship between two products, the cross price elasticity of demand is zero.

Industrial Dynamics – Business Decision Making

As stated previously, firms observe the relationships of changes in price and thus on demand, with this in mind, it is now appropriate to assess the importance and impact of income and cross elasticities of demand on the business decisions taken by management executives.

The Decision Making Process

Firms determine their strategies according to their short to long term objectives. Whether the firm’s objectives are to increase turnover or introduce a new product for example, it would become essential for the firm to analyze indicators in the economy.

The decisions of a firm relating to investment, price, profit, etc. are based on the firm’s evaluation of behaviour of other, competing firms, and the expected response of the market. The firm’s knowledge of the market and knowledge of the future behaviour of competitors is limited and uncertain. Firms’ decisions can thus only be suboptimal. The decisions are taken simultaneously and independently by all firms at the beginning of each period (e.g. once a year or a quarter). After the decisions are made the firms undertake production and put the products on the market. The products are evaluated by the market, and the quantities of different firms’ products sold in the market depend on the relative prices, the relative value of products’ characteristics and the level of saturation of the market. In the long run, a preference for better products, i.e. those with a lower price and better characteristics, prevails.

In the decision-making procedure the price, investment, profit and production are established by applying some local optimization procedure. The decision-maker chooses first of all a set of crucial (primary) variables influencing the objective and on the basis of which it is possible to estimate all other characteristics of the economic process (for example, the product price plays the role of the primary variable in decision-making procedure). By relating this design to Income Elasticity of Demand or Cross Elasticity of Demand, the firm will analyze economic data that examines the current relationship between consumers’ income or of demand for a product to a change in the price of other related products, and consequently devise the best pricing strategy that will capitalise on current market behaviour.

Summary

Elasticity is an important conception in understanding the incidence of indirect taxation (i.e. income tax), marginal costs, different types of goods, and consumer choice and business decision making. Elasticity, specifically Income Elasticity and Cross Elasticity as we have assessed here, is key in a firms business objectives and are two of the determinants of how feasible a strategy is in the real market. Business Management and Economics are interdependent and hence have a reciprocal impact on each other.

Bibliography

Begg, David, “Economics”

Fifth Edition

Sloman, J, Economics for Business

Third Edition

References