Change
in people’s income would affect demand. For most of the goods and
services income and quantity demanded will move in the same direction.
A
rise in income will bring about an increase in their demand; these commodities
are called normal goods.
Normal goods are income elastic whereas inferior quality goods are income
inelastic. Like that, necessary goods are income inelastic
and luxury goods are income elastic.
Income elasticity of demand [ YED where Y represent income] is a
measurement of the responsiveness of the quantity demanded to a change in
income.
YED
(Income elasticity of demand) = % Change in Quantity demand /
% Change in income.
When
% Change Quantity demand is greater than % Change in income it is Income elastic; when
% Change Quantity demand is less than % Change in income it is Income inelastic.
Types of goods affecting income elasticity
Change
in people’s income would affect demand. The following nature of goods and
services influence Income elasticity of demand. For most of the goods and
services income and quantity demanded will move in the same direction.
A
rise in income will bring about an increase in their demand; these commodities
are called normal goods. Normal
goods are income elastic.
The
level of demand for some goods or service could decline with increase in
income, these are called inferior goods. Inferior goods are income inelastic. [Irrespective of price
increase people are ready to buy necessary goods like essential
food materials; medicines etc. and they are income inelastic.]
Finally
luxury goods of lavishness are income
elastic. Income elasticity of demand is also related to the revenue.
Therefore it is very important for suppliers in deciding the size of their
business. If the product has income elastic demand, when there is
an increase in the income of consumers the revenue of the suppliers
would also increases.
Cross elasticity of demand
Another
important factor affects the demand for one commodity is the prices of other
commodities. If two goods are substitutes, a rise in price of one will
cause a rise in demand for the other good.
Cross elasticity of demand is a measurement of the
responsiveness of the quantity demanded to a change in the Price of another
good.
It
is measured by the following formula
Cross
elasticity of demand =
%
Change in quantity demand one good / % Change in the price of other good
(The
other good may be either substitute or a complimentary good)
Price
of other goods may also sometimes determine the demand of a commodity. The type
of goods may be substitute or complement good.
For
Substitute goods the value of cross
elasticity of demand would be positive. They are Cross elastic demanded.
[Value of Cross Elasticity of Demand for Substitute Goods (+)]
The
value of cross-elasticity of demand
would be negative for complementary goods and it is cross-inelastic
demanded. [Value of Cross Elasticity of Demand for Complimentary Goods
(-)]
This
is very important for firms for their production decision. It is also a
main concern of government because the prices of domestic goods can affect the
level of imports and thereby affecting the Balance of payment.