Income Elasticity of Demand
Prepared By: Milan Padariya
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Aims: To understanding the concept of YeD
To have written and numerate understanding of elasticity figures (elastic & inelastic)
To understand the implications for revenue and profit (and therefore decision-making);
Formula
Income elasticity of demand (Yed) measures the relationship between a change in quantity demanded and a change in real income
Yed = % change in demand % change in income
There are 3 different types of Income Elastic
Goods
Income Elasticity of Demand:
Normal Good – demand rises as income rises and vice versa
Inferior Good – demand falls as income rises and vice versa
Look out for the sign…!
A positive sign (+) denotes a normal good
A negative sign (-) denotes an inferior good
The details you need to know
Normal goods have a positive income elasticity of demand
As consumers’ income rises, so more is demanded at each price level
Normal goods have an income elasticity of demand of between 0 and +1
Luxuries have an income elasticity of demand > +1
So the demand rises more than proportionate to a change in income
Inferior goods have a negative income elasticity of demand.
Demand falls as income rises
The detailed knowledge
+ Positive Income Elasticity
A rise in income will cause a rise in demand
A fall in income will cause a fall in demand
Coffee example…. A 10% increase in income will result in a 2.3% increase in demand for coffee.
What’s the YeD? What will this look like on a D & S diagram?
Positive Income Elastic Demand Diagram
Note the axes are DIFFERENT!
Elastic or Inelastic + YeD
Elastic goods – are seen as LUXURIES OR SUPERIOR!
Inelastic goods – are seen as NORMAL or NECESSITIES.
- Negative Income Elasticity
An increase in income will result in a decrease in demand.
A decrease in income will result in a rise in demand.
ALSO known as INFERIOR GOODS
Negative Income Elasticity
Potatoes are seen as a inferior product
Potatoes have a YeD of -0.48
So a 10% rise in incomes will result in????
What would this look like on a D&S diagram?
Negative Income Elasticity Diagram = Inferior
Note the different axes labels
Zero Income Elasticity
This occurs when a change in income has NO effect on the demand for goods.
A rise of 5% income in a rich country will leave the Demand for toothpaste unchanged!
So to summarise
Look for the signs!
LUXURY GOODSNORMAL GOODS
INFERIOR GOODS
BETWEEN 0 & 1
+0.5 +0.9 + 0.1+ + GREATER THAN 1
+2 +5 +27
- CAN BE A DECIMAL OR A VALUE GREATER THAN 1
For example: Yed = - 0.6:
Good is an inferior good but inelastic
a rise in income of 10% would lead to demand falling by 6%
Yed = + 0.4: Good is a normal good but inelastic
a rise in incomes of 10% would lead to demand rising by 4%
Yed = + 1.6: Good is a normal good and elastic
a rise in incomes of 10% would lead to demand rising by 16%
Yed = - 2.1: Good is an inferior good and elastic
a rise in incomes of 10% would lead to a fall in demand of 21%
So what’s a Normal, a Luxury and an Inferior
good?
In groups of 3’s …You will each be ‘given’ a set of goods and
you have to decide whether each is a normal,
luxury or an inferior good…
You decide…. Bus travel Cigarettes Designer clothes Fine wines Fresh vegetables Frozen vegetables Fruit juice Instant coffee International air travel Luxury chocolates
Margarine Stilton Private education Private health care Stringy cheese Rail travel Shampoo Tinned meat Value “own-brand” bread
Bus travel Cigarettes Designer clothes Fine wines Fresh vegetables Frozen vegetables Fruit juice Instant coffee International air travel Luxury chocolates
Margarine Natural cheese Private education Private health care Processed cheese Rail travel Shampoo Tinned meat Value “own-brand” bread
So which would have a negative – value? i.e. an inferior good?
So which would have a + value BETWEEN 0 AND 1?
i.e. a NORMAL good?
So which would have a + value GREATER THAN 1?
i.e. a LUXURY good?
A Diagram for you…
Relationship between Income and Quantity Demanded
Qua
ntity
Income y2y10
Positive income elasticity
Zero income elasticity Negative income elasticity
[inferior good]
Income Elasticity of Demand for Chocolate
Total consumption USA 0.79 Germany 0.39 United Kingdom 0.44 France 0.60 Japan 0.08 Switzerland 1.06
Reference: Henri Jason Trends in cocoa and chocolate consumption with particular reference to developments in the major markets. Malaysian International Cocoa Conference, Kuala Lumpur, 20-21 October 1994 (ICCO, ED(MEM) 686)
Which country has the sweeter tooth when it comes to
income elasticity for chocolate??
Income Elasticity and the Demand for Airline Travel
Demand for air travel has a positive income elasticity of demand
The industry is cyclical
During an upturn, demand rises for business and leisure travel)
During a recession, the demand tails away
In the long run, there is a positive relationship between real GDP per capita and the demand for air travel
Income elasticity will vary according to the type of air travel
E.g. difference between low-cost “no-frills” and higher priced scheduled services on low-haul flights
Examples of YeD
For example:
Yed = - 0.6: Good is an inferior good but inelastic – a rise in income of 10% would lead to demand falling by 6%
Yed = + 0.4: Good is a normal good but inelastic – a rise in incomes of 10% would lead to demand rising by 4%
Yed = + 1.6: Good is a normal good and elastic – a rise in incomes of 10% would lead to demand rising by 16%
Yed = - 2.1: Good is an inferior good and elastic – a rise in incomes of 10% would lead to a fall in demand of 21%
YeD mantra… + = normal- = inferior!
Your handout has different figures…
annotate these to your handout
Income Per Capita and Airline Travel by Country
Croatia
Paraguay
Zimbabw e Turkey
Syria Poland
Iran Algeria China
Bangladesh
India Cameroon
Vietnam
Pakistan Cote D'Ivoire
Peru Philippines Sri Lanka
Kenya
Costa Rica
Panama Thailand
Dominican Rep Lebanon
Argentina Czech Rep
Uruguay Slovenia
Belgium France
Germany Finland
Sw eden
Israel
Ireland Spain
Portugal
Chile
Korea Rep Greece Saudi Arabia
Malaysia Austria
Italy
Canada Netherlands UK
New Zealand Australia Sw itzerland US
Hong Kong China
Singapore
Japan Norw ay
Denmark
Venezuela Mexico
S. Africa
Hungary Colombia
Brazil Tunisia
Lithuania Romania
Ecuador
Belarus Ukraine
Nigeria
Bulgaria
10
100
1000
10000
100000
0 5000 10000 15000 20000 25000 30000 35000
GNP per capita ($ PPP)
AS
K (
000)
per
cap
ita
Why do you think New Zealand,
Australia, Hong Kong and Singapore are
above the trend line?
Airlines – a Highly Cyclical Industry
0
1
2
3
4
5
6
7
8
1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001
-4
-2
0
2
4
6
8
10
12
14
16World real GDP growth (% vly)
World scheduled airline RPKs (% vly)
Real GDP growth% year on year
Global air traffic% year on year
What does this mean?
Significance of Income Elasticity of Demand
High Income Elasticity
Demand is sensitive to changes in real incomes
Demand is therefore cyclical – in an economic expansion, demand will grow strongly. In a recession demand may fall
Can be difficult for businesses to accurately forecast demand and make capital investment decisions
Significance of Income Elasticity of Demand
Low Income Elasticity
Demand is more stable during fluctuations in the economic cycle
Over time, the share of consumer spending on inferior goods and normal necessities tends to decline
Long run – businesses need to invest in / focus on products with a higher income elasticity of demand if they want to increase total profits
Practice time….
This is NOT exam practice!
The exam paper will NOT look like this!
Income elasticity of demands in a recession
Define YeD
What is the formula?
What type of YeD would you expect a luxury good should have?
Identify the different types of YeD in the table…
Product YeD
Luxury choc 2.4
Whisky 4.1
Digestive Biscuits
0.6
Apples 0.2
Own brand baked beans
-0.4
Income elasticity of demands in a recession
Estimate the effect a 5% fall in income would have on each product.
Estimate the effect a 15% increase in income would have on each product.
Product YeD
Luxury choc 2.4
Whisky 4.1
Digestive Biscuits
0.6
Apples 0.2
Own brand baked beans
-0.4