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IB Diploma Economics:
Income Elasticity of Demand
Income Elasticity of Demand
Income elasticity of demand (YED) is a measure of the relationship between a change in the quantity demanded for a particular good and a change in real income.
Income elasticity of demand measures the responsiveness of the quantity demanded for a good or service to a change in the income of the people demanding the good, ceteris paribus. It is calculated as the ratio of the percentage change in quantity demanded to the percentage change in income.
Given a change of income, the value of YED provides us with information about the direction of the change in demand (increase or decrease) as well as the size of the change in demand (the size of the shift of the demand curve).
Income Elasticity Explained
Any change in income can have three possible effects on consumer demand.
Calculating income elasticity of demand
When changes in income and quantity demanded are given in percentages, then income elasticity of demand is calculated using the following formula:
Example calculation: It is observed that when incomes decrease by 10%, demand for sausages increases by 4%.
YED = +4 ÷ –10 = –0.4
Unlike price elasticity of demand, positive and negative numbers are very important in calculating XED. We do not take the absolute value because negative and positive percentage changes will provide valuable insight into how the two goods are related – whether they are substitute or complement goods.
In the case of normal goods, income and demand is positively related. An increase (+) in income will lead to an increase (+) in QD for good X. Conversely, a decrease (–) in income will lead to a decrease (–) in QD for X.
→ +/+ = positive
→ –/– = positive
However, In the case of inferior goods, income and demand is negatively related. An increase (+) in income will lead to a decrease (–) in QD for good X. Conversely, a decrease (–) in income will lead to an increase (+) in QD for X.
→ +/– = negative
→ –/+ = negative
If income and quantity demanded information is given in numeric terms, it is our strong recommendation that you convert this information into percentage terms and then do your YED calculation. There is another formula you can use, but, it is reasonably complex and remember that in the IB Economics exams you will not be provided with formulas. Do not waste mental energy memorising a complex formula! Here is how to calculate a percentage change:
Example calculation: Consumer income increases from $50 000 to $53 000, and the quantity demanded of good X increases from 10 units to 13.
→ % change in income = [($53 000 - $50 000) ÷ $50 000] x 100 = +6%
→ % change in Qd = [(13 - 10) ÷ 10] x 100 = +30%
→ XED = +30 ÷ +6 = +5
Interpreting Income elasticity of demand
Necessity goods: A type of normal good. Like any other normal good, when income rises, demand rises. But the increase for a necessity good is less than proportional to the rise in income, so the proportion of expenditure on these goods falls as income rises.
Inferior goods: A good that decreases in demand when consumer income rises (or rises in demand when consumer income decreases), unlike normal goods, for which the opposite relationship between income and consumer demand is observed.
Necessity goods such as food, housing and transport usually have a YED that is positive and less than one; i.e., they are normal goods that are income elastic. Take food for example, as income increases people buy more food and better quality more expensive food. However, as proportion of total income, the increase in quantity demanded increases at a slower rate than total income.
In contrast, spending on luxury goods and services such as overseas travel, restaurant meals and private education increases faster than income.
Luxury goods: A type of normal good. Like any other normal good, when income rises, demand rises. However, demand increases more than proportionally as income rises, and is in contrast to a "necessity good", for which demand increases proportionally less than income.
Essential statement: The more responsive quantity demanded becomes to changes in consumers’ income, the positive value of YED increases as demand becomes more elastic.
factors that affect income elasticity of demand:
There are various factors that affect income elasticity of demand:
- Income levels determine whether a good is a necessity or a luxury. Food has a YED of about 0.20 in developed countries and around 0.80 in less developed countries. Thus for every 10% increase in average incomes in the UK, for example, expenditure on food only increase by around 2%, whereas in Zimbabwe a 10% increase in average incomes would result in around an extra 8% being spent on food.
- Perceptions are influential too. In wealthy countries a common consumer good such as coffee may be seen as a necessity, whereas in poorer countries coffee may well be seen as a luxury to impress the in-laws pop when they drop by for a visit.
- YED will change over the product life cycle. Demand for cell phones was very much income elastic when they were first introduced to the market – they were luxury goods. Now however, they are seen as necessities, at least in developed countries, where every middle school student would have one and a significant proportion of the population would have more than one.
- YED can be influenced by marketing. For example, the demand for bread is income elastic as it is a necessity. However, with the right marketing, expensive speciality and artisan breads will be income elastic, with demand increasing proportionally faster as incomes rise.
The implications of YED for firms and the economy:
The rate of industry expansion
The rate of industry expansion. As incomes in an economy increase there is an increasing demand for goods and services. Suppose that an economy has an annual long-term average rate of income growth of three per cent. For goods and services that are income elastic (YED > 1), this means that demand will increase by more than three per cent. Conversely, for goods and services where the industry has income inelastic demand (YED < 0) then demand will increase by less than three per cent. Assuming increased economic growth in the future, the higher the value of YED for an industry, the greater the share of the economy that industry will have over time. And, the more income inelastic an industry is, the relative size of the industry within an economy will decrease over time.
Thus, income elastic goods will become relatively more important for a country’s economic growth and employment, and income inelastic goods less important, over time.
Sectors of the economy
Sectors of the economy. Every economy has three sectors: primary (agriculture, fishing and mining), secondary (manufacturing) and tertiary (services).
Primary products: Involves the retrieval and production of raw materials, such as corn, coal, wood and iron. (A coal miner and a farmer would be workers in the primary sector.)
Manufacturing: Involves the transformation of raw or intermediate materials into goods e.g. manufacturing steel into cars, or textiles into clothing. (A builder and a dressmaker would be workers in the manufacturing sector.)
Services: Involves the supplying of services to consumers and businesses, such as baby-sitting, cinema and banking. (A shopkeeper and an accountant would be workers in the services sector.)
With economic growth, the relative size of each sector will change over time. Income elasticity of demand can explain these changes.
As economies grow and real income per capita increases, then industries within the different sectors of the economy will experience different rates of growth depending on the income elasticity of demand of their products. Primary commodities such as food (meat, dairy, fruit and vegetables, etc.) have relatively inelastic YED and over time, and with increased real household incomes, the agricultural sector of the economy will come to represent proportionally less of all economic activity within a country.
The business cycle
The business cycle. Real GDP tends to increase over time that is to say that there is a long-term trend towards economic growth and increasing economic activity. However, the trend of increasing real GDP is not smooth. Economies will have times when real GDP is increasing faster than at other times, economies will have times of slowly increasing GDP, times of economic stagnation, small decreases in real GDP and economic recessions – where real GDP growth is negative for two or more quarters and economic activity declines. In recessions, where there is increased unemployment and little if any wage growth, average consumer incomes are declining.
Spending on necessity goods and services (e.g., transport, electricity and housing) would remain relatively stable to cyclical variations in economic activity, whereas firms in luxury industries (e.g., tourism and hospitality) would experience a larger decrease in demand.
In short, industries that have products that are highly income elastic have increased volatility associated with the business cycle – demand will increase rapidly during an economic expansion and decrease just as quickly in periods of economic contraction. Industries producing goods and services with income inelastic demand will have much more stable output and employment of resources across the cyclical variations of the business cycle.
The Business Cycle explained
Manufacturing industries will continue to grow, up to a point, as economic growth boosts incomes. As consumer income increases, manufactured goods such as televisions and computers generally have relatively elastic demand.
Increasing incomes will mean more of these manufactured goods will be produced and consumed and output and employment in these industries will expand relative to industries within the agricultural sector.
Service industries such as banking, insurance, travel and hospitality are the most income elastic and increases in income spur high levels of growth within these industries. For example, the higher a consumer’s income the more expensive her house and the more expensive her insurance premiums. In developed economies, where incomes are highest, firms operating in the service sector account for the bulk of economic activity and output. And, inelastic primary products account for only a small percentage of all economic output and employment.
PROGRESS CHECK - TEST YOUR UNDERSTANDING BY COMPLETING THE ACTIVITIES BELOW
You have below, a range of practice activities, flash cards, exam practice questions and an online interactive self test to ensure you have complete mastery of the IB Economics requirements for the Microeconomics: 1.7 Income Elasticity of Demand topic.