Master of Business Administration

EAST AFRUCAN COLLAGE

Individual Assignment of Managerial Economics 2

Mohammed Abdukadir
IDNO:- PGR/00205/15
 Clearly explain each of the following terms and their application and rule in Income
Elasticity of Demand.

a. Normal good

b. Inferior good

c. Necessity

d. Luxury good

Income Elasticity of Demand (YED) is defined as the responsiveness of demand when a

consumer’s income changes. It is defined as the ratio of the change in quantity demanded over
the change in income.

The higher the income elasticity, the more sensitive demand for a good is to changes in income.
This means that a very high-income elasticity of demand suggests that when a consumer’s
income goes up, consumers will buy a lot more of that good and, reciprocally, when income goes
down consumers will cut back their purchases of that good to an even higher degree. A very low
price elasticity implies that changes in a consumer’s income will have little effect on demand.

YED is useful for governments and firms to help them decide what goods to produce and how a
change in overall income in the economy affects the demand for their products, i.e., whether
it’s inelastic or elastic.

YED can be positive or negative. This depends on the type of good. A normal good has a
positive sign, while an inferior good has a negative sign.

For example, if a person experiences a 20% increase in income, the quantity demanded for a
good increased by 20%, then the income elasticity of demand would be 20%/20% = 1. This
would make it a normal good.

Income Elasticity of Demand Formula

The formula for calculating the Income Elasticity of Demand is defined as the ratio of the change
in quantity demand over the change in income.
We can express this as the following:

YED = (New Quantity Demand – Old Quantity Demand)/(Old Quantity Demand) / (New
Income – Old Income)/(Old Income)

Types of Income Elasticity of Demand

We can categorize income elasticity of demand into 5 different categories depending on the
value.

Normal goods have a positive income elasticity of demand so as consumers’ income increase,
there is an increase in quantity demand.

Necessities have an income elasticity of demand of between 0 and +1. For example, a staple like
rice or bread could be considered a necessity.

Inferior goods have a negative income elasticity of demand meaning that demand falls as income
rises.

1. Income Elasticity of Demand for a Normal Good

A normal good has an Income Elasticity of Demand > 0. This means the demand for a normal
good will increase as the consumer’s income increases.

2. Income Elasticity of Demand for an Inferior Good

An inferior good has an Income Elasticity of Demand < 0. This means the demand for an inferior
good will decrease as the consumer’s income decreases.

3. Income Elasticity of Demand for a Luxury Good

Luxury goods usually have Income Elasticity of Demand > 1, which means they are income
elastic. This implies that consumer demand is more responsive to a change in income. For
example, diamonds are a luxury good that is income elastic.

4. Relatively Inelastic Income Elasticity of Demand

0 < Income Elasticity of Demand < 1 are goods that are relatively inelastic. This means that
consumer demand rises less proportionately in response to an increase in income.

5. Income Elasticity of Demand is 0

Income Elasticity of Demand = 0 means that the demand for the good isn’t affected by a change
in income.

Income Elasticity of Demand Example

Let’s take an example of a shop that sells widgets. They estimate that when the average real
income of its customers falls from $60,000 to $40,000, the demand for its widgets falls from
5,000 to 4,000 units sold, with all other things remaining the same.

Using the income elasticity of demand formula,

YED = (New Quantity Demand – Old Quantity Demand)/(Old Quantity Demand) / (New
Income – Old Income)/(Old Income)

= (4,000 – 5,000)/(5,000) / (40,000-60,000)/(60,000)

= ~0.67

This produces an elasticity of 0.67, which indicates customers are not particularly sensitive to
changes in their income when it comes to buying these widgets. The demand does not fall
significantly with a fall in income.

Engel Curve

Engel Curves show how demand curves are sloped in response to changes in income. A goods
Engel curve reflects its income elasticity and indicates whether the good is an inferior, normal, or
luxury good. Engel’s law which states that the poorer a family is, the larger the budget share it
spends on nourishment.
Curve 2 – Inferior Goods

The Engel curve has a negative gradient. That means that since the consumer has more income,
they will buy less of the inferior good because they can purchase better products.

Curve 3 – Normal Goods

It has a positive gradient. As income increases, the quantity demanded increases. Amongst
normal goods, there are two possibilities. Although the Engel curve remains upward sloping in
both cases, it bends toward the Y-axis for necessities (Curve 1) and towards the X-axis for
luxury goods.

Uses of Engel Curves

Engel curves are used for equivalence scale calculations and related welfare comparisons, and to
determine properties of demand systems such as agreeability and rank.

Engel curves have also been used to study how the changing industrial composition of growing
economies are linked to the changes in the composition of household demand.
Reference
 Managerial handout
 https://legalpaathshala.com/profit-maximization
 https://www.vedantu.com/commerce/positive-and-normative-economics
 https://en.wikipedia.org/wiki/Managerial_economics#:~:text=Managers%20study%2
0managerial%20economics%20because,that%20apply%20to%20economic%20behav
ior.&text=The%20first%20step%20in%20making,the%20problem%20in%20its%20e
ntirety.
 https://legalpaathshala.com/managerial-economics
 https://www.vedantu.com/commerce
 https://www.intelligenteconomist.com/income-elasticity-of-demand/