Income Elasticity of Demand

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Income Elasticity of Demand 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);

Income Elasticity of Demand 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

Income Elasticity of Demand 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 Income Elasticity of Demand 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! NORMAL GOODS LUXURY GOODS INFERIOR 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

Income Elasticity of Demand 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? Income Elasticity of Demand 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…

Income Elasticity of Demand 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

Income Elasticity of Demand 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

A Diagram for you…

Relationship between Income and Quantity Demanded Zero income elasticity Quantity Negative income elasticity [inferior good] Positive income elasticity y1 Income y2

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)

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

Your handout has different figures…annotate these to your handout 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 figures…annotate these to your handout

Income Per Capita and Airline Travel by Country Why do you think New Zealand, Australia, Hong Kong and Singapore are above the trend line?

Airlines – a Highly Cyclical Industry What does this mean? Real GDP growth % year on year Global air traffic % year on year

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

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