Question

2. What is the income elasticity of demand? How can it be used to determine whether a good is a normal good or an inferior good? What is the cross-price elasticity of demand? How can it be used to determine whether two goods are substitutes or compliments?

Answer 1

Income elasticity of demand is defined as the degree of responsiveness in quantity demand for a good due a change in income of the consumer. It can be calculated as:

IED = % change in quantity demanded of a good / % change in income of the consumer

A positive income elasticity of demand is associated with normal goods, where as a negative income elasticity of demand is associated with inferior goods.

Cross-price elasticity of demand is defined as the degree of responsiveness in quantity demand for one good (good X) due a change in the price of another good (good Y).

It can be calculated as:

CPED = % change in quantity demanded for a good X / % change in the price of good Y

A positive cross-price elasticity of demand is associated with substitute good, where as a negative cross-price elasticity of demand is associated with complementary good.