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Income elasticity of demand

Income elasticity of demand (YED) shows the effect of a change in income on quantity demanded. Income is an important determinant of consumer demand, and YED shows precisely the extent to which changes in income lead to changes in demand. YED can be calculated using the following equation:
% change in () quantity demanded % change in () income (Y)

Normal goods
When the equation gives a positive result, the good is a normal good. A normal good is one where

demand is directly proportional to income. For example, if, following an increase in income from 40,000 to 50,000, an individual consumer buys 40 DVD films per year, instead of 20, then the coefficient is:
+100 +25 = (+) 4.0

The positive sign means that the good is a normal good, and because the coefficient is greater than one, demand for the good responds more than proportionately to a change in income. This indicates the good is not a necessity like food, and would be considered a relative luxury for this individual.

Inferior goods
When YED is negative, the good is classified as inferior. For example, if, following an increase in income from 40,000 to 50,000, a consumer buys 180 loaves of bread per year instead of 200, then the YED is:
+-10 +25 = (-) 0.4

The negative sign means that the good is inferior, and, because the coefficient is less than one, demand for the good does not respond significantly to a change in income. This indicates that the good is not particularly inferior compared with a good which has a YED of > (-)1. The sign and the number provide different information about the relationship between income and demand. Income elasticity of demand can also be illustrated by Engel curves.

Video Why does a firm want to know YED?


There several reasons why a firm would want to know YED, including the following:

Sales forecasting
A firm can forecast the impact of a change in income on sales volume (Q), and sales revenue (P x Q). For example, a hypothetical car manufacturer has calculated that YED with respect to its luxury car is (+) 3.8, and it has also undertaken research to discover that consumer incomes will rise by 2% next year. It can now predict the impact of this change. Exercise Using the YED equation, calculate the effect on sales. The same producer sells a small car with a YED of (-) 5. Using the YED equation, and assuming income also increases by 2%, calculate the effect on sales. Answers

Pricing policy
Knowing YED helps the firm decide whether to raise or lower price following a change in consumer

incomes. If incomes are falling and YED is positive, a reduction in price might help compensate for the reduction in demand.

Diversification Firms can diversify and offer a range of goods with different YEDs to spread the risks associated with changes in the level of national income. For example, a car manufacturer may produce cars with a range of YED values, so that sales are stabilised as the economy grows and declines. YED and the business cycle
Changes in real national income tend to be cyclical. The demand for normal goods increases when the economy is expanding, but decreases when the economy is contracting. Conversely, the demand for inferior goods is counter-cyclical.

The higher the positive value for YED, the greater the effect of a change in national income on consumer demand.

income elasticity of demand


Introduction Income elasticity of demand measures the relationship between a change in quantity demanded and a change in income. The basic formula for calculating the coefficient of income elasticity is: Percentage change in quantity demanded of good X divided by the percentage change in real consumers' income Normal Goods Normal goods have a positive income elasticity of demand so as income rise more is demand at each price level. We make a distinction between normal necessities and normal luxuries (both have a positive coefficient of income elasticity). Necessities have an income elasticity of demand of between 0 and +1. Demand rises with income, but less than proportionately. Often this is because we have a limited need to consume additional quantities of necessary goods as our real living standards rise. The class examples of this would be the demand for fresh vegetables, toothpaste and newspapers. Demand is not very sensitive at all to

fluctuations in income in this sense total market demand is relatively stable following changes in the wider economic (business) cycle. Luxuries on the other hand are said to have an income elasticity of demand > +1. (Demand rises more than proportionate to a change in income). Luxuries are items we can (and often do) manage to do without during periods of below average income and falling consumer confidence. When incomes are rising strongly and consumers have the confidence to go ahead with big -ticket items of spending, so the demand for luxury goods will grow. Conversely in a recession or economic slowdown, these items of discretionary spending might be the first victims of decisions by consumers to rein in their spending and rebuild savings and household financial balance sheets. Many luxury goods also deserve the sobriquet of positional goods. These are products where the consumer derives satisfaction (and utility) not just from consuming the good or service itself, but also from being seen to be a consumer by others. Inferior Goods Inferior goods have a negative income elasticity of demand. Demand falls as income rises. In a recession the demand for inferior products might actually grow (depending on the severity of any change in income and also the absolute co-efficient of income elasticity of demand). For example if we find that the income elasticity of demand for cigarettes is -0.3, then a 5% fall in the average real incomes of consumers might lead to a 1.5% fall in the total demand for cigarettes (ceteris paribus).

Within a given market, the income elasticity of demand for various products can vary and of course the perception of a product must differ from consumer to consumer. The hugely important market for overseas holidays is a great example to develop further in this respect. What to some people is a necessity might be a luxury to others. For many products, the final income elasticity of demand might be close to zero, in other words there is a very weak link at best between fluctuations in income and spending decisions. In this case the real income effect arising from a fall in prices is likely to be relatively small. Most of the impact on demand following a change in price will be due to changes in the relative prices of substitute goods and services.

The income elasticity of demand for a product will also change over time the vast majority of products have a finite life-cycle. Consumer perceptions of the value and desirability of a good or service will be influenced not just by their own experiences of consuming it (and the feedback from other purchasers) but also the appearance of new products onto the market. Consider the income elasticity of demand for flat-screen colour televisions as the market for plasma screens develops and the income elasticity of demand for TV services provided through satellite dishes set against the growing availability and falling cost (in nominal and real terms) and integrated digital televisions.

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