UNIT-1(PART 1)

TOPICS COVERED
 Importance of Price Elasticity of demand
 Income Elasticity of Demand(Theory)
 Cross Elasticity of Demand(Theory)
 IMPORTANCE OF PRICE ELASTICITY OF DEMAND
Price elasticity of demand (PED) is a concept that tells us how much the quantity
demanded of a product changes when its price changes. In simple words, it measures
how sensitive customers are to price changes.
Why is it important?
1.Helps Set Prices Smartly
Knowing how to price: If a business knows that the demand for their product is elastic
(customers are very sensitive to price changes), they might avoid raising prices too much
because even a small increase could cause a big drop in sales. On the other hand, if
demand is inelastic (customers aren’t very sensitive to price changes), the business could
increase prices without losing many customers.
Example: A luxury clothing brand might find that its customers are sensitive to price
changes (elastic demand), so they might be cautious about raising prices. But for a
business selling essential items like medicine, where customers need the product no
matter the price (inelastic demand), they may have more freedom to adjust prices.
2.Maximizes Revenue
Optimizing sales and revenue: Understanding PED helps businesses predict how
changing prices will affect their total revenue. If demand is elastic, lowering prices could
boost sales so much that it increases total revenue. If demand is inelastic, raising prices
might not reduce sales much, so the business can earn more revenue from each sale.
Example: A coffee shop might lower its prices during off-peak hours if it knows that
demand is elastic during that time, hoping to attract more customers and increase
overall revenue.
3. Improves Business Strategy
Staying competitive: Businesses can use PED to strategize against competitors. If they
know that their product's demand is elastic, they might offer discounts or promotions to
attract price-sensitive customers. If the demand is inelastic, they can focus less on
competing on price and more on improving quality or services.
Example: A grocery store might run sales on everyday items like bread or milk if they
know customers will flock to lower prices (elastic demand). But for a specialty product
with inelastic demand, like organic health supplements, the store may keep prices
stable.
4.Supports Better Inventory Management
Managing stock wisely: Businesses with a good understanding of PED can better
manage their inventory. If demand for a product is highly elastic and prices change
frequently, they might avoid overstocking to reduce the risk of unsold items. If demand
is inelastic, they can keep more stock because customers are less likely to reduce
purchases even if prices rise.
Example: A company selling electronics might reduce inventory levels if they know
price increases will cause demand to drop (elastic demand). But a utility company
might keep more stock of essential items like energy-saving bulbs since demand won’t
fall much, even if prices go up (inelastic demand).
5. Guides Long-Term Growth Decisions
Planning for the future: Businesses need to understand PED to make long-term
investment decisions. Products with inelastic demand are often seen as more stable
and reliable for long-term growth because their sales are less affected by price
fluctuations. On the other hand, products with elastic demand may need constant
adjustments and promotions to maintain growth.
Example: A company that sells basic household necessities, like soap or toothpaste
(with inelastic demand), might focus on long-term growth because these items are
always in demand. However, a tech company that sells luxury gadgets (with elastic
demand) might need to innovate constantly and adjust prices to keep growing.
6. Affects Marketing and Promotions
Tailoring promotions: Businesses use PED to decide when and how to run promotions
or discounts. If they know demand is elastic, running a sale might boost demand
significantly. But if demand is inelastic, discounts may not lead to a big jump in sales, so
promotions might be unnecessary.
Example: A retailer might run a back-to-school promotion for items like school
supplies, knowing that a small discount could attract many price-sensitive parents
(elastic demand). But for high-end electronics, they might not offer many discounts
because they know the demand isn’t as price-sensitive (inelastic demand).
In summary, price elasticity of demand helps businesses make smarter decisions about
pricing, revenue, inventory, and long-term growth. It allows them to adapt to customer
behavior, stay competitive, and plan for the future effectively.
 INCOME ELASTICITY OF DEMAND
Income elasticity of demand (YED) measures how much the quantity demanded of a
good or service changes in response to a change in consumers' income. In simple terms,
it tells us how sensitive demand for a product is to changes in people's income levels.
 Determinants of Income Elasticity of Demand
1.Nature of the Good
Necessities vs. Luxuries:
• Necessities: Goods that people need to survive (like food, water, and basic clothing)
usually have low income elasticity. Even if people earn more or less, they still need to
buy these items, so demand doesn’t change much.
• Luxuries: Goods that are not essential but add comfort or status (like high-end
electronics, designer clothes, and vacations) have high income elasticity. When
people earn more money, they tend to spend more on these luxury goods.
• Example: Bread is a necessity, so even if income increases, people won’t buy that
much more of it. But a sports car is a luxury, so if income rises, demand for sports
cars might increase sharply.
2.Income Level of Consumers
Wealth of the Consumers: People with higher incomes tend to have a lower sensitivity
to income changes for basic goods because they already have their needs met. In
contrast, people with lower incomes are more likely to change their spending habits
when their income changes, particularly for essentials.
Example: A wealthy person might not significantly increase their grocery spending if
they get a raise, but someone with a lower income might buy better-quality food or more
groceries as their income rises.
3.Time Period
Short-Term vs. Long-Term: In the short term, demand may not change much with
income fluctuations because people need time to adjust their consumption patterns. In
the long term, as people get used to their higher or lower income, their demand for
certain goods may increase or decrease more significantly.
Example: Right after getting a raise, a person might not immediately buy a new car or
move to a bigger house, but over time, as they adjust their spending, they might
eventually make those bigger purchases.
4.Consumer Expectations
Future Income Expectations: If people expect their income to rise or fall in the future,
they may adjust their spending today. For example, if they anticipate earning more, they
might start buying luxury goods even before their income increases.
Example: If someone expects a promotion or bonus soon, they might start spending
more on discretionary items like entertainment or travel in anticipation of the extra
income.
TYPES OF INCOME ELASTICITY OF DEMAND
1.Positive Income Elasticity (Normal Goods)
When YED is greater than 0: This means that when people's income goes up, they buy
more of the product.
Two Types:
a. Luxury Goods (YED > 1): When income increases, people spend much more on
these goods. These are typically non-essential, high-end products.
• Example: Expensive watches, luxury vacations.
b. Necessities (0 < YED < 1): When income increases, people spend a bit more on
these essential goods, but not as much as luxury items.
• Example: Basic food items like bread or milk.
2. Negative Income Elasticity (Inferior Goods)
When YED is less than 0: This means that when people's income goes up, they buy less
of the product. These are lower-quality or cheaper alternatives.
Example: Second-hand clothes- people buy less of these when they can afford better
options.
3. Zero Income Elasticity
When YED is equal to 0: This means that changes in income don’t affect how much
people buy. Demand stays the same no matter how much people earn.
Example: Life-saving medicines or basic health services.
4. Unitary Income Elasticity
When YED equals 1: Demand increases or decreases at the same rate as income. If
income goes up by 10%, demand also goes up by 10%.
It holds for those normal goods which fall between the category of necessities and
luxuries.
Example: Mid-range items like casual dining or mid-tier clothing brands
IMPORTANCE OF INCOME ELASTICITY OF DEMAND
1.Helps Businesses Forecast Demand
Understanding Market Trends: Businesses can predict how their sales will change as
the economy grows or contracts. If they sell luxury goods (with high YED), they know
that during economic booms, demand will rise quickly, but during recessions, demand
may fall sharply.
Example: A company selling high-end electronics might expand during a booming
economy because demand will increase rapidly as people earn more money.
2.Guides Pricing and Product Strategies
Targeting the Right Products: YED helps businesses decide which products to focus on.
If a product has high income elasticity, they may target wealthier customers or create
premium versions. If a product has negative YED (inferior goods), businesses may focus
on lower-income customers or offer more budget-friendly options.
Example: A company may launch a luxury product line when incomes rise or introduce
low-cost alternatives during an economic downturn.
3. Supports Business Expansion Decisions
Entering New Markets: YED helps companies decide where to expand. If a country is
experiencing rapid economic growth, businesses selling goods with high income
elasticity (like luxury or premium goods) might enter that market to capitalize on rising
incomes.
Example: A luxury car manufacturer might expand to an emerging market where
middle-class incomes are increasing rapidly.
4. Helps Governments Make Better Decisions
Taxes and Social Programs: Governments use income elasticity of demand (YED) to
understand how changes in people’s income, like from tax cuts or welfare programs, will
affect what they buy. This helps them decide how to design tax policies or offer financial
help.
Example: If people have more money because of lower taxes, they might buy more
luxury items, which could change how much tax the government collects from those
goods.
 CROSS-PRICE ELASTICITY OF DEMAND
Cross elasticity of demand (XED) measures how the demand for one product changes in
response to a price change of another related product. It shows whether two goods are
substitutes, complements, or unrelated.
• Substitutes: If an increase in the price of one good causes demand for another good to
rise (like coffee and tea) and vice-versa, they are substitutes.
• Complements: If an increase in the price of one good causes demand for another good
to fall (like printers and ink) and vice versa they are complements.
Determinants of Cross Elasticity of Demand
1.Type of Goods (Substitutes or Complements):
• Substitutes: Products that can replace each other (e.g., Pepsi and Coke).
• Complements: Products that are used together (e.g., cars and gasoline).
2. The main determinant of cross-price elasticity is the nature of the commodities relative
to their uses. If two commodities can satisfy equally well the same need(i.e., they are
close subsitutes), the cross-price elasticity is high and vice versa.

 TYPES OF CROSS-PRICE ELASTICITY

1.Positive Infinity (+∞)
Perfect Substitutes: If XED is +∞, the goods are perfect substitutes. Even a tiny price
increase in one good causes all consumers to switch to the other good.
Example: Two identical brands of bottled water. A small price rise in one brand leads
everyone to buy the other brand instead.
2.Positive XED (XED > 0)
Substitutes: When XED is positive, the goods are substitutes. As the price of one good
increases, the demand for the other good also increases, but not perfectly.
Example: If the price of coffee rises, more people might buy tea as a substitute.
3.Zero Cross Elasticity (XED = 0)
Unrelated Goods: When XED is 0, the goods are unrelated. A price change in one good
does not affect the demand for the other good at all.
Example: The price of books has no impact on the demand for apples.
4.Negative XED (XED < 0)
Complements: When XED is negative, the goods are complements. As the price of
one good increases, the demand for the other decreases.
Example: If the price of cars increases, demand for gasoline might decrease since fewer
cars will be bought.
5. Negative Infinity (-∞)
Perfect Complements: If XED is -∞, the goods are perfect complements. A price
increase in one good completely eliminates demand for the other good.
Example: Right and left shoes. If the price of right shoes goes up significantly, demand
for left shoes drops to zero because they are only used together.
 IMPORTANCE OF CROSS-ELASTICITY OF DEMAND
1.Understanding Market Competition
Substitute Products: XED helps businesses understand how their products compete
with others. If two products have high positive XED, they are strong substitutes, and a
price change in one will directly affect the demand for the other.
Example: A company selling cola will closely monitor the price of its competitors' drinks
to predict shifts in demand for its own product.
2. Pricing Strategies
Price Sensitivity: Businesses can use XED to adjust pricing strategies. If a product has a
strong substitute, a price increase might lead customers to switch to the competitor's
product. On the other hand, if the product is a complement, lowering the price of one
good may boost demand for another related product.
Example: A razor company might sell razors at a very low price or even at a loss (a
strategy known as a "loss leader") to drive up the sales of razor blades, which are
complementary products. Since customers need blades to continue using the razor, the
company can recover profits through higher blade sales.
3.Product Bundling and Marketing
Complementary Products: Firms with complementary products can bundle them or
run joint promotions to maximize sales. By understanding XED, they can anticipate how
changes in one product's price will influence demand for another.
Example: A company selling printers might offer discounts on ink cartridges when
customers buy a printer, knowing that these goods are complements.
4. Business Expansion and Mergers
Strategic Decisions: XED helps businesses decide on expansion and mergers. If a
company finds that its products have a strong complementary relationship with
another firm's products, it might consider merging or forming strategic alliances to
boost sales of both.
Example: A car manufacturer might partner with a tire company if they have a high
negative XED, indicating a strong complementary relationship.
 References
 Textbooks
 Internet Sources
THANKS