Own Price, Cross Price and Income Elasticity

We studied elasticity in a previous post:

The percentage change in quantity demanded, given a percentage change in price.

In today’s post, we expand the definition of elasticity a little. That naturally makes it a little complicated, but it also enriches our understanding of it – a good bargain.

What if the price of a substitute changes? What if, that is, the price of Coke changes a little. By what percentage will the quantity demanded of Pepsi change? The measurement of such a thing is called cross price elasticity (substitute).

The percentage change in quantity demanded, given a percentage change in the price of a substitute.

The first definition above is therefore the definition of own price elasticity, while the second one is of cross price elasticity. Cross price elasticity, naturally, will be of twp types – that of complements, and that of substitutes.

There is yet a fourth type of elasticity, called income elasticity of demand. As you might imagine, it is

The percentage change in quantity demanded, given a percentage change in income.

Say your income in a particular month goes down by 10 percent. Is it reasonable to imagine that you will therefore cut back on your consumption of movies in a theatre, or dinners in restaurants? Unless you are a hardcore movie buff, or love eating out a lot, the answer would probably be yes. The income elasticity of demand for these goods is therefore high.

On the other hand, will you cut back your consumption of pills prescribed by your doctor? Almost definitely not, right? The income elasticity of demand for these goods is therefore low.

And that concludes our series on the basics of supply and demand!

Here’s a quick recap:

The demand (and supply) of a good depends upon:

  1.  it’s own price
  2. the price of complements and substitutes
  3. it’s own price elasticity
  4. the cross price elasticities
  5. the income elasticity
  6. changing tastes and preferences
  7. changing incomes

As you can no doubt see, thinking about demand is fairly complex – but it is, nonetheless, rewarding. In the next post, we’ll give you a list of resources for learning more about demand and supply (as we did for the Solow model), and then begin a new topic.

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Tastes, Preferences and Income

Remember CD’s? They used to be the last word in convenient storage, and if you are of a particular age or higher “AVSEQ01.dat” will be a very evocative term indeed.

CD’s these days are available for around 15 rupees each, down from about 50 rupees a while ago, and maybe even higher. The law of demand that we have been learning about all this while suggests that the demand for CD’s should go up, since the price has come down.

Ah, but who uses CD’s these days? All the music you’d ever want to listen to and more is available on multiple streaming services. YouTube ensures that you have more video content to watch than is humanly possible, while services such as Netflix and Amazon Prime have made CD and DVD players ancient relics.

In other words, tastes and preferences of people have changed, and they will not want to buy CD’s, no matter the cost. So it’s not just the price of a good, nor that of complements and substitutes that matters – it also is whether or not you want to buy the good at all or not.

And to complicate matters even further, it’s not just tastes and preferences – it’s also income!

Remember dalda? Every Indian household used to use it in the 1980’s, but families today won’t go within sniffing distance of the stuff. That’s because, generally speaking, incomes have been rising, and households now have the money to make health-conscious choices – which means dalda is out, not matter the price.

And you could say the same thing for landlines, cassette recorders, cathode ray televisions, desktops, dumbphones – and that’s just from the world of electronics. As societies progress, they experience a rise in incomes and a change in tastes and preferences – and these things impact both the demand and supply of goods.

So, in a nutshell:

The price of a good, its elasticity, the price of its complements and substitutes, changes in incomes, tastes and preferences all impact the demand (and supply) of a particular good.

Next, we’ll take a look at cross price elasticity and income elasticity.

Examples of elasticity

Here’s a question for you: when was the last time you passed a petrol pump and saw a discount offer on fuel?

Unless you have a very vivid recollection of your dreams, the answer is always going to be: never.

And why am I able to say that so confidently? Because, in the lingo of the economist, petrol is an inelastic good. That is, as per our last post, the quantity demanded doesn’t decrease all that much, even for very large increases in price.

If society has to be able to move goods and people across long distances, one can’t yet escape the need to refuel vehicles. Mr. Musk is single-handedly trying to change the truth value of that statement, but as things stand, one can’t do without petrol. So even if prices were to be raised, demand wouldn’t change all that much. And which is why it doesn’t make sense to offer discounts on petrol either! Because, if you can sell high quantities without giving discounts – well then, why give discounts in the first place?

This is true for cigarettes too. Not matter what the price, people will buy. And which is why finance ministers in every budget feel very safe in raising the tax on cigarettes – because people will pay.

On the other hand, Myntra sells clothes people don’t especially need, and is one of a thousand sellers (online and offline) in the business of selling a bewildering variety of clothes. If Myntra wants people to buy from them, they’re going to have to offer those clothes at a discount. That’s elastic demand.

And in fact, that last point we made is crucial to understand about elasticity. If there are a number of alternatives available, the elasticity will be high. If there are a low number of alternatives available, the elasticity will be low.

So the trick, as an entrepreneur, is to build a product that people absolutely want to  -need to! – buy, but also build a product that has no real alternative. You may absolutely want a cup of chai in the evening, but there will be a dozen chaiwallahs in your neighbourhood. On the other hand, you may be the only seller selling neon pink umbrellas with prickly handles – there’s no real alternative to your product, sure – but people don’t seem to want to buy it.

Inelastic products hit that sweet spot that combine both of these features, and that allows the company responsible for that product to reap the profits. Apple is the easiest example around, but there are so many more examples around us. Perhaps the best way of understanding elasticity is to try and come up with some examples from the world around you. Give it a shot!

In the next post, we’ll take a look at two related concepts: complements, and substitutes.

Explaining Elasticity

Open any micro textbook, and this is the definition of elasticity of demand that you will find (more or less):

“The percentage change in quantity demanded, given a percentage change in price”

Here is what it means, in practice. Say you’re a shopkeeper selling plain black umbrellas. Let’s say you sell them for a hundred rupees each. At this price, every month, you are able to sell 100 of them.

One especially sleepy Tuesday afternoon, you think to yourself that it’s been a while since I hiked the price at which I sell these umbrellas, so let’s start selling ’em at 110 rupees tomorrow.

All right, so do you still expect to sell 100 umbrellas this month, now that the price is 110 instead of 100? Do you expect to sell more than 100, less than 100? The answer to this question is the elasticity of demand for plain black umbrellas in your shop. One would think it’s fair to assume that the demand will go down with an increase in price. By how much, though?

There’s been a 10 percent increase in price. Will there be a 10 percent decrease in demand? If so, then the elasticity of demand for black umbrellas is -1. Economists usually leave out the “minus” since that’s more or less a given. If the percentage change in quantity demanded is the same as the percentage change in price, we say that the good in question has unitary elasticity.

What if there is a higher than 10 percent change in quantity demanded given a percentage change in price? What if, say, the percentage change in quantity demanded is 20 percent – what if you now sell only 80 umbrellas? In that case 20/10=2 – the elasticity will be 2.

Here’s the math: 20 percent because (80-100)/100=-20 percent, and 10 percent because (110-100)/100=10 percent.

We call the demand for such goods elastic. That is, a slight change in price leads to large changes in demand.

Similarly, if there is a small fall in demand – say, you sell 99 umbrellas instead of 100, elasticity in that case would be 0.1 (try and work out the math yourself). And we would then call the demand for this good inelastic. That is, changes in price have little to no impact upon quantity demanded.

If you’re learning about elasticity for the first time, though, it might be best to not get caught up in the math right away, and think through the intuition:

If I increase the price of a good a little bit, will the change in quantity demanded be as much as the change in price, or less, or more?

The quantifiable response to that question is the measurement of elasticity. It’s what allows Apple to never give a discount on their latest iPhones, and it’s what keeps goods on Myntra on near permanent sales.

And we’ll be taking a look at some real life examples in the next blog post!

 

3 factors that impact demand and supply

The Gurugram story that we learnt about in the previous post was a fairly simple one. We spoke about how people on both sides of the divide (demand and supply) think about prices and therefore their decisions about how much to supply and how much to demand. Alas, if it were only that simple.

As it turns out, there are many, many other factors at play when it comes to thinking about demand and supply. In this post, we are going to list out these factors, and in the posts to follow, we’re going to speak about each one of them in turn.

First, the existence of things that may be substitutes, and things that may be complements to the thing being analyzed. For example, flats/apartments may be one thing, but what about bungalows? A bungalow is a substitute for an apartment. Will a change in the price of bungalows affect the demand for apartments? If so, how? Buying an apartment also means, presumably, hiring an interior decorator.  Will the rates being charged by an interior decorator impact the decision to buy a flat? This is the analysis of complementary goods and substitute goods – one part of the puzzle.

Second, a change in taste and preferences. For example, with a rise in incomes, people may not want to stay in apartments, but in bungalows. Conversely, if there is a fall in income, people may not want to stay in apartments, but in slums. These things also impact our analysis.

Third, how sensitive is demand to a change in price. Very large changes in prices may not impact the demand for cigarettes all that much (and any finance minister worth his salt will tell you this), while very small changes in price will change the demand for jewellery significantly.

Each of these are factors that impact significantly both the demand and supply of a good, as as we mentioned, in the three posts that follow, we will take a look at each one of them, beginning with the third factor listed above: elasticity.

Why do Bhai’s films never fail?

I haven’t seen Sultan yet, and I may end up not watching it, but I have seen my fair share of Bhai films (it’s only a matter of time before it becomes a genre by itself, capital B and all). And they’re entertaining, there’s no doubt about that.

As an economist who’s learnt about rational human beings though, there’s a lot that causes befuddlement where Bhai movies are concerned. In this post, though, I’m just focusing on one of these aspects: first weekend prices for Bhai movies.

Apparently, they’ve gone as high as 1200 per seat. Now, you might say, if you’re a Bhai acolyte, that it’s just because demand tends to be so high for His films. But it’s not just high demand (and this is what this post is all about), it’s also about inelastic demand.

Us economists are big on elasticity, and you’re about to find out why. Elasticity (or sensitivity) is simply the percentage by which demand goes down when prices go up. If, for a little change in price, there is a very large change in demand, we say a good is very price elastic. If, on the other hand, no matter what the change in price, demand stays the same, we say a good is very price inelastic.

Think cigarettes. Or Bhai films. Same story.

Now, demand can change because of a lot of things. It can change because income goes up or down, for example. A family that sees a drop in income might cut back on eating out (high income elasticity), but will not cut down on medicines (low income elasticity). It can change because the price of other goods goes up or down (drinking lesser chai because the prices of sugar have gone through the roof, or drinking more coffee because the prices of chai have gone through the roof).

All of these are examples of demand for a good changing (or not) because of a change in the price of that good, an associated good, or income. And that’s all elasticity is.

Of course, as recent events have proved, the demand for Bhai’s films is inelastic insensitive to what he says as well, but that’s a whole different story, okay?