Income Elasticity of Demand

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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)

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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

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There are 3 different types of Income Elastic
Goods
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Income Elasticity of Demand

• Normal Good demand rises as income rises and
  vice versa
• Inferior Good demand falls as income rises and
  vice versa

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Look out for the sign!

• A positive sign () denotes a normal good
• A negative sign (-) denotes an inferior good

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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

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The detailed knowledge
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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?

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Positive Income Elastic Demand Diagram

• Note the axes are DIFFERENT!

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Elastic or Inelastic YeD

• Elastic goods are seen as LUXURIES OR SUPERIOR!

• Inelastic goods are seen as NORMAL or
  NECESSITIES.

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- 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

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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 DS diagram?

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Negative Income Elasticity Diagram Inferior

• Note the different axes labels

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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!

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So to summarise
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Look for the signs!

• LUXURY GOODS

• NORMAL GOODS

GREATER THAN 1 2 5 27
BETWEEN 0 1 0.5 0.9 0.1

• INFERIOR GOODS

-
CAN BE A DECIMAL OR A VALUE GREATER THAN 1
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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

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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

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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

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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?
So which would have a negative value? i.e. an
inferior 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

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A Diagram for you
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Relationship between Income and Quantity Demanded
Zero income elasticity
Quantity
Negative income elasticity inferior good
Positive income elasticity
0
y2
y1
Income
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Income Elasticity of Demand for Chocolate
Which country has the sweeter tooth when it comes
to income elasticity 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)

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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

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Examples of YeD
YeD mantra normal - inferior!

• 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

Your handout has different figuresannotate these
to your handout
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Income Per Capita and Airline Travel by Country
Why do you think New Zealand, Australia, Hong
Kong and Singapore are above the trend line?
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Airlines a Highly Cyclical Industry
What does this mean?
Global air traffic year on year
Real GDP growth year on year
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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

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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

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Practice time.

• This is NOT exam practice!
• The exam paper will NOT look like this!

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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

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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.

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Homework

• RED sheet
• Complete Questions