Question

QUESTION THREE [20]

3.1 Discuss, with the aid of examples, how income elasticity of demand and cross-price elasticity of demand can be used to define goods and services. (12)

3.2 Supply and demand for normal goods and services tends to be more elastic in the short-run than the long-run. Provide a motivation for this economic phenomenon

Answer 1

3.1

Income elasticity of demand can be taken as a measure to define the features and characteristic of the goods and services. Income elasticity is defined as the degree of responsiveness of quantity demanded due to change in income of the consumer.

A high and positive income elasitcity tells us that the good in question luxury good. For example, an iPhone is a luxury good because a small change in income leads to larger change in the demand for apple phones.

Similarly, daily necessities like bread, butter, sugar etc have lower income elasticity. An increase in the consumer's income will not influence the consumer to purchase more quantity of bread.

Cross Price elasticity talks about the effect of price change in one good on the quantity demanded of other good. This type of elasticity is used to differentiate between Substitute and Complementary good.

If cross elasticity is > 0, then two goods are said to be substitutes. For example, an increase in the price of Coke increases the quantity demanded of Pepsi leading to positive cross elasticity imply that both Coke and Pepsi are substitutes of each other.

3.2

Supply and demand for normal goods and services tends to be more elastic in the short-run than the long-run

In the short run, consumer faces very less time in order to adjust as per the demand and supply conditions. The degree of responsiveness of demand and supply in the shorter run, therefore, tends to be highly sensitive towards change in the price. Elasicites are therefore greater than 1 and demand and supply curves are flatter.

However, in the long run, consumer adusts to economic conditions and makes changes in the consumption expenditure accordingly. Any price change in the short run will have a gradual decreasing impact in the long run. As a result, the curves become more steeper and elasticities reduce.