Eco 101 Income and Cross Elasticity

Here's a quick review of what we know.

Elasticity is basically the responsiveness of demand to changes in price.

There are three equations for elasticity. They all work.

Relative Change in Demand/Relative Change in Price

/\ Q / Avg Q
/\ P / Avg P

(Avg P / Avg Q) X (1 / Slope)

INCOME ELASTICITY OF DEMAND IS EXACTLY THE SAME, except instead of responding to changes in Price, demand is responding to changes in Income. As such, we use 'Y' instead of 'P' in the formula

Relative Change in Demand/Relative Change in Price

/\ Q / Avg Q
/\ Y / Avg Y

(Avg Y / Avg Q) X (1 / Slope)

There are two main kinds of goods which are affected by changes in income in different ways.

Normal goods are items which respond positively to changes in income. If your income increases, you buy more of them. As your income decreases, you buy less of them. These include items such as cars or food.

Inferior goods are abnormal goods (although not necessarily of lower quality) which repond negatively to income changes. You buy less of them as your income increases, and more of them as your income decreases. This includes things like Wal-Mart shoes and craft dinner, but it is also dependent on personal tastes. Some inferior goods may be consumed less as income increases, because education also increases as income increases, and these products are considered unhealthy.

LUXURY: Movies (3.5) Electricity (2.0) Autos (1.0) --------> Elasticity is greater than 1
NECESSITIES: Furniture (0.5) Clothing (0.5) Food (0.2)-----> Elasticity is less than 1, but still positive
INFERIOR: Whole Milk (-0.5) Pig Products (-0.2)---------> Elasticity is negative

There are two factors which determine the elasticity of income:
1: Characteristics of the good
2: Taste Preferences

The nature of the good itself will define elasticity, but often, preferences will determine the necessity level of a good. Often, as income increases, there is a move away from staple foods to produce and meats, to restaurant meals.

CROSS ELASTICITY OF DEMAND: The sensitivity of demand in one product to price changes of another product

Relative Change in Demand for Product X/Relative Change in Price for Product Y

/\ QX / Avg QX
/\ PY / Avg PY

(Avg PY / Avg QX) X (1 / Slope)

There are two different scenarios here:

COMPLIMENTARY GOODS: Eg, CDs and Walkman Players
THESE HAVE A NEGATIVE CORRELATION
In other words, the cross elasticity of demand for complimentary goods is negative.

SUBSTITUTE GOODS: EG, Pepsi and Coke
THESE HAVE A POSITIVE CORRELATION
In other words, the cross elasticity of demand for substitute goods is positive

Here is a case scenario which could make us think about the cross elasticity of substitute goods. Gateman was, at one point, down in Ottawa to study this case. Here, Fritto-Lay (a subsidiary of Pepsico) was essentially buying out Hostess Chips (through a multimillion dollar merger). The government saw that this was essentially the creation of a monopoly in the potato chip industry, and rushed in to prevent the merger. The company lawyers for Fritto-Lay, however, were able to conclusively prove that the merger would not, in effect, create a monopoly, because in real markets, other goods such as popcorn and cheese puffs serve as de facto substitute goods for potato chips. Potato chips have a higher cross elasticity of demand with these substitute snack foods, so as a result, Fritto-lay would not be able to create a real market monopoly. Frito-Lay naturally won the case and was allowed the merger..... Hooray!

Econ-101-Elasticity continues

Announcements: It's flu season, apparently. If you're sick, don't show up. It's that simple!

Review:
Elasticity of Demand: The sensitivity of quantity demanded to changes in price

Relative change in Q
Relative change in P

or

/\Q / Average Q
/\P / Average P

or

(Average P / Average Q) X (1 / Slope)

It's an oversimplification, but flat demand is more elastic, and steep demand is less elastic. This is due to the increase or decrease in inverted slope
Also, more right-shifted demand curves are less elastic than left-shifted demand curves. This is due to the increase or decrease in average quantity demanded at any price

HOKAY!

Why do we get different sensitivity rates to price changes (elasticity rates) for different products?
Why are certain firms able to get away with 'jacking up the price' of certain products?

THE ANSWER:
Different degrees of availability of substitutes products (outputs on the demand side) effect elasticity. The more options, and higher the quality of available substitutes, the easier it will be for consumers to simply buy a substitute product if the price of a good increases. This means that it is easier for consumers to respond to price changes by lowering or heightening demand for products with many viable substitutes...

MORE SUBSTITUTES = HIGHER ELASTICITY

The more specific a product is, the higher elasticity will be.

Coke is much more elastic as a good than 'pop'
Pop is much more elastic as a good than 'fluids'

TIME PERIOD EFFECTS THINGS
Over time, competition increases, the availability of substitutes increases, and elasticity increases.

PERCEPTION ALSO EFFECTS THINGS
products viewed as 'luxury' items will simply not be purchased if their price is raised. How consumers perceive products effects elasticity.

HOKAY Time for comparisons

NAME SHAPE ELASTICITY REASON
perfectly inelastic vertical line 0 demand never changes with price
inelastic steep line less than 1 /\ Q < /\ P
unit elastic rectangular hyperbola 1 /\ Q = /\ P
elastic flat line more than 1 /\ Q > /\ P
perfectly elastic horizontal line infinite price never changes with demand

THE PRICE ELASTICITY OF SUPPLY!
-the responsiveness of supply to changes in price
-the formulas are the same...

HOWEVER, unit elasticity is a straight line through the origin, not a rectangular hyperbola. Why- ask Jude Drutz!

Here, elasticity is determined by the availability of substitute inputs!
The more viable substitute factors of production you have to work with as a producer, the more elastic the supply if your product will be.

EG: you farm wheat and oats. It is fairly easy to divert production towards wheat if the price of wheat increases, because wheat is a substitute input for many other grain products, it is also easy to divert production away from wheat, because it uses the same machinery and land as other substitute crops. SO WHEAT has a high price elasticity of supply.

Durin fruit is difficult and unique to farm. It requires a very specific method to cultivate and harvest, which is not used to cultivate other fruits. It is very difficult to change the production quantity of Durin in response to price changes, so Durin has low elasticity.

FIN