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3.1 Income Elasticity of Demand

# 3.1 Income Elasticity of Demand

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01/28/2013

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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);

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 Good – demand falls as income rises and vice versa

 Inferior

Look out for the sign…!
A

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

A

The details you need to know

Normal goods have a positive income elasticity of demand

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

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

The detailed knowledge

+
A A

Positive Income Elasticity
rise in income will cause a rise in demand 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.

 An A

Negative Income Elasticity

increase in income will result in a decrease in demand. 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 have a YeD of -0.48

 Potatoes

 So

a 10% rise in incomes will result in???? would this look like on a D&S diagram?

 What

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 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…

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

0

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% in

Your handout has different figures…  Yed = - 2.1: Good is an inferior goodannotate these to your and elastic – a rise handout incomes of 10% would lead to a fall in demand of 21%

100000

Income Per Capita and Airline Travel by Country
Singapore Hong Kong China New Zealand Israel Australia Sw itzerland US

Netherlands Canada Denmark UK 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 TunisiaHungary Argentina Sri Lanka Colombia Czech Rep Zimbabw e Kenya Bulgaria Turkey Uruguay Croatia Cote D'IvoireSyria Slovenia Lithuania Pakistan Paraguay Romania Poland Ecuador

100

VietnamChina Algeria Iran Cameroon Belarus India Ukraine Nigeria Bangladesh

Why do you think New Zealand, Australia, Hong Kong and Singapore are above the trend line?
30000 35000

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

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

8 7 6 5 4 3 2 1 0

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

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 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
Luxury choc Whisky

YeD 2.4 4.1 0.6 0.2 -0.4

Digestive Biscuits Apples Own brand baked beans

Income elasticity of demands in a recession

Estimate the effect a 5% fall in income would have on each product.

Product
Luxury choc Whisky

YeD 2.4 4.1 0.6 0.2 -0.4

Estimate the effect a 15% increase in income Digestive Biscuits would have on each Apples product.
Own brand baked beans

Homework
RED

sheet Questions

Complete

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