Income Elasticity of Demand

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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

Homework

RED sheet

Complete Questions