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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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.