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

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

Normal goods have an income elasticity of demand of between 0 and +1

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. Whats 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!

NORMAL

GOODS

LUXURY GOODS

BETWEEN 0 & 1 +0.5 +0.9 + 0.1

GREATER THAN 1 +2 +5 +27

INFERIOR

GOODS

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 whats a Normal, a Luxury and an Inferior good?

In groups of 3s 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

So which would have negative value So which would have aa++value So which would have a GREATER AND 1? BETWEEN 0THAN1? value? i.e. an inferior good? i.e. NORMAL good? i.e. a a LUXURY good?

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

A Diagram for you

Relationship between Income and Quantity Demanded

Quantity

Zero income elastici ty

Positive income elasticity

Negative income elasticity [inferior good]

y1

Income

y2

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
Which country has the sweeter tooth when it comes to income elasticity for chocolate??

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)

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 mantra + = normal - = inferior!

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 incomes of 10% would lead to a fall in demand of 21%
Your handout has different figuresannotate these to your handout good and elastic a rise

in

100000

Income Per Capita and Airline Travel by Country

Singapore Hong Kong China New Zealand Israel US

10000

Australia

Sw itzerland

ASK (000) per capita

Netherlands Canada Denmark UK Ecuador Norw ay Spain France Japan Malaysia Finland Belgium Saudi Arabia Greece Ireland eden Germany Sw Portugal Austria Thailand Panama Korea Rep Dominican Rep 1000 Italy S. Africa Lebanon Chile Costa Rica Mexico Brazil Venezuela Peru Philippines Hungary Argentina Tunisia Sri Lanka Why do you think Colombia Czech Rep Zimbabw e Kenya Bulgaria Turkey New Zealand, Uruguay Cote D'IvoireSyria Croatia Slovenia Australia, Hong Kong Lithuania Pakistan Paraguay Romania Poland

100

VietnamChinaAlgeria Iran Cameroon Belarus India Ukraine Nigeria Bangladesh

and Singapore are above the trend line?

10 0 5000 10000 15000 20000 25000 30000 35000 GNP per capita ($ PPP)

Airlines a Highly Cyclical What does this Industry mean?

Real GDP growth % year on year Global air traffic % year on year

8 7 6

World real GDP growth (% vly) World scheduled airline RPKs (% vly)

16 14 12 10

5 4 3 2

8 6 4 2 0

1 0
1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999

-2 -4
2001

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

Product
Luxury choc Whisky Digestive Biscuits Apples

YeD 2.4 4.1 0.6 0.2

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

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
Luxury choc Whisky

YeD 2.4 4.1 0.6 0.2

Digestive Biscuits Apples

Own brand baked beans

-0.4

Homework
RED

sheet

Complete

Questions