Income elasticity of demand

and
Price elasticity of supply
 Income elasticity of demand
• Income elasticity of demand (YED) is a measure of
the responsiveness of demand to changes in income.
• It is referred to as the % change in quantity
demanded by the % change in income (Y).
• YED can be calculated using the following formula:
YED =
• Given a change in income, YED provides
information on the direction of change of demand
and on the size of the change.
 Interpretation of YED
Income elasticity of demand provides us with
two kinds of information:
• The sign of YED: positive or negative
• The numerical value of YED: whether it is
greater than or less than one (given is is
positive)
 The sign of YED
• The sign of YED determines whether the good is
normal or inferior.
• Income elasticity of demand is positive (YED> 0) when
demand and income change in the same direction.
• A positive YED indicates that the concerned good is
normal
• Income elasticity of demand is negative (YED< 0) when
demand and income change in opposite directions.
• A negative YED indicates that the concerned good is
inferior (ex. second- hand clothes, vehicles, bus rides)
• The difference between normal and inferior goods
can be seen in the following diagram.
• The graph shows a demand curve, D, and shifts of the
curve that occur in response to increases in income.
• As income increases, the demand curve shifts
rightward from D to D2 or D3 when goods are
normal (YED > 0),
• On the other hand, as income decreases the demand
curve shifts leftward to D1 when goods are inferior
good (YED < 0).
 The numerical value of YED
• YED<1: If a good has a YED that is positive but
less than one, it has income inelastic demand.
Necessities are income inelastic goods.
• YED>1: If a good has an YED that is greater than
one, it has income elastic demand. Luxuries are
income elastic goods.
• Considering a good as a necessity or luxury
depends on income levels. For people with
extremely low incomes, food and clothing can be
luxuries.
 Applications of YED
• YED and producers: Following economic growth
the income of individuals increases, resulting in
higher demand for goods and services.
• The higher the YED for a good or service, the
greater the expansion of its market in the future;
the lower the YED, the smaller the expansion.
• On the other hand, when an economy experiences
recession, goods and services with high YEDs tend
to decline in sales, while those with low YEDs
avoid serious drop in sales.
• YED and the economy: Every economy consists of
three sectors- the primary sector, the secondary
sector, and the tertiary sector.
• Following economic growth, the size of these sectors
tend to change over time, which is dependent on the
YEDs of various goods.
• For example, agriculture as an important element of
the primary sector involves food production, which
has a low positive YED.
• As income increases, the growth in demand for food
and other primary products is slower than the growth
of income
• In contrast, manufactured products have a YED
greater than one.
• As the society’s income grows, the demand for
these products grows faster than income.
• Many services have even higher YEDs, so the
percentage increase in the demand for these is
much larger.
• Hence, over time, the share of agricultural output
in total output within in the economy shrinks,
while the share of manufactured and service
sectors grow.
• YED and impacts on the prices of primary goods: a
low YED for food indicates that as income rises the
proportion of it spent on food decreases, while the
proportion spent on manufactured goods increases.
• This has important implications for the level of
prices of agricultural products in comparison to the
prices of manufactured products over the long- term.
• As incomes rise, the demand for manufactured
products and services rises more rapidly than the
demand for food. Ultimately, the prices of these
goods and services rise more rapidly than the prices
of agricultural products.
Price elasticity of supply (PES)
• So far we have looked at elasticities in relation to
demand, involving the responsiveness of
consumers.
• Now we’ll be looking at Price elasticity of Supply
(PES), a measure of the responsiveness of the
quantity supplied by firms to the changes in price.
• It is referred to as the % change in quantity
supplied by the % change in price
• PES can be calculated using the following formula
PES=
 Degrees of PES
• The value of PES involves the comparison between
the percentage changes of both the price and
quantity supplied.
• As a result this comparison gives out a range of
several values for the range of PES.
• The values range from 0 to 1; O being highly price
inelastic supply, and 1 being highly price elastic
supply.
Let’s discuss this further using some diagrams:
 10%
10%

15%

5%
 Price inelastic supply (0>PES<1)
• The percentage change in quantity supplied is
smaller than the percentage change in price.
• The value of PES is <1; quantity supplied is
relatively unresponsive to changes in price. Supply
is price inelastic.
• This is seen in (a) where a 10% increase in price
from P1 to P2 results in only a 5% decrease in
quantity supplied from Q1 to Q2
Price elastic supply (1>PES<∞)
• The percentage change in quantity supplied is
larger than the percentage change in price.
• The value of PES is >1; quantity supplied is
relatively responsive to the changes in price.
Supply is price elastic.
• This is seen in (b) where a 10% increase in price
from P1 to P2 results in a 15% increase in quantity
supplied from Q1 to Q2.
 Unit elastic supply (PES= 1)
• The percentage change in quantity supplied is
equal to the percentage change in price.
• The value of PES is =1; change in quantity
supplied is equal to the change in price. Supply is
unit elastic.
• This is seen in (c) where the PES of the three
supply curves S1, S2, and S3 is equal to 1.
• This is because for any straight line passing
through the origin, the percentage change in price
is equal to the percentage change in quantity
supplied.
 Perfectly inelastic demand (PES=0)

• There is no change in quantity supplied.

• The value of PES is =0; change in quantity
supplied is unaffected by changes in price. Supply
is perfectly inelastic.
• This is seen in (d) where the quantity supplied is
fixed and remains at Q1, irrespective of the
changes in price.
Perfectly elastic demand (PED=∞)
• A change in price results in an infinitely large
response of the quantity supplied.
• The value of PES is =∞; Producers are willing to
supply any quantity of the good at a fixed price.
Supply is perfectly elastic.
• This is seen in (e) where the price is fixed and
remains at P1, while offering different quantities
of the good supplied at the same price.
 Determinants of PES
• Length of time: an important factor for firms to
adjust their inputs, influencing the response of
quantity supplied to the changes in price.
• Over a short time, firms find it difficult to increase
or decrease their inputs in order to adjust the
quantity supplied, causing it to be price- inelastic.
• As the length of time available to firms increases,
the responsiveness of quantity supplied to price
changes begins to rise, and PES increases.
Let’s discuss this further using an example
• A fishing boat returns with a stock to supply in the
market. Despite an increase in price, the quantity
of fish supplied is unaffected.
• As the length of time that firms have increases, the
responsiveness of quantity supplied to price
changes begins to rise, and PES increases.

Let’s use a diagram for a better understanding:

• The supply curve, S represents the fixed quantity
of fish available in the market.
• Over time, more labour are hired for fishing and
the boat is taken out to sea more often.
• The quantity of fish supplied, shown by the curve
S1, increases from Q to Q1, as the price rises from
P to P1.
• At this point the quantity supplied is inelastic,
since a 10% increase in price results in only a 3%
increase in quantity supplied (low responsiveness).
• If it takes even longer, the responsiveness of the
quantity supplied increases.
• The owner of the fishing boat can now hire more
labour, and increase the number of fishing boats.
• This increases the supply of the fish stock, resoling
in a more elastic supply as shown by the curve S2.
• As the supply becomes more elastic, the quantity is
increasingly responsive to price changes. A 10%
increase in price results in a large responsiveness
of 15% of the quantity supplied.
• Mobility of factors of production: The ease and
speed with which firms can shift the available
resources between different products.
• The more easily the resources are shifted from one
production process to another, the greater the
responsiveness of quantity supplied and the PES.
• Factor mobility involves the movement of factors
between firms within an industry. For example,
when one steel plant closes but sells its production
equipment to another steel firm.
• Mobility may involve the movement of factors
across industries within a country. For example,
when a worker leaves employment at a textile firm
and begins work at an automobile factory.
• Thirdly, mobility involves the movement of factors
between countries within or across industries, such
as when a worker migrates to another country or
when a factory is moved abroad.
• Spare capacity of firms: Sometimes firms may
have capacity to produce that is not being used
(for example, factories or equipment may be idle
for some hours each day).
• If this occurs, it is relatively easy for a firm to
respond with increased output to a price rise. But
if the firm’s capacity is fully used, it will be more
difficult to do so.
• The greater the spare capacity the higher is PES;
the less the spare capacity the smaller the PES
• Ability to store stocks: Some firms store stocks of
output they produce but do not sell right away.
• Firms that are able to store stocks are likely to
have a higher PES for their products than firms
that cannot store stocks.
• However, this affects the PES only over relatively
short periods, because once stocks are released in
the market and sold, other factors determining
PES (as discussed previously) are involved.
 Applications of PES
• We’ll be looking at two main applications of PES:
* PES in relation to primary and manufactured
goods
- Why primary goods have a low PES compared to
manufactured goods
- Consequences of a low PES for primary goods
* Short- run and long- run price elasticity of supply
 PES in relation to primary and
manufactured goods
• Primary goods usually tend to have a low PES as time
is needed for quantity supplied to respond to price
changes.
• For example in agriculture, it takes a lot of time and
resources to produce the concerned good (ex. food
crops) since farmers need a season for planting.
• Given the limitations of resources lacking in specific
regions, it’s important to make advancements in
production, which takes time and hence the reasoning
behind primary goods with a low PES.
• In the case of other primary products, such as oil,
natural gas and minerals, time is needed to make
investments and to begin production.
• Because of the costs involved, firms do not
respond quickly to price increases, and wait for a
serious shortage of the good to arise before they
take actions to increase production.
 Consequences of a low PES
• We have seen previously that price inelastic
demand for primary products is an important
factor contributing to short-term price and
revenue instability for producers (ex. farmers).
• Similarly, price inelastic supply of primary
products also contributes to price and income
instability for primary product producers.
Let’s use a set of diagrams to understand this better:
• Both the diagrams (a) and (b) show fluctuating
demand curves due to price fluctuations
• Graph (a) shows demand fluctuations in relation to
inelastic supply, which is common for primary goods.
• Graph (b) shows demand fluctuations in relation to
elastic supply, which is common in the case of
manufactured goods
• Comparing the two diagrams, it’s clear that price
fluctuations are larger due to inelastic supply,
resulting in revenue instability for the producers of
primary products.
PES over the long- run and short- run

• As seen earlier, primary goods usually have lower

price elasticities of supply than manufactured
products because they need more time to respond
to price changes.
• Over long periods of time the PES of primary
goods increases. The longer the time producers
take to make the necessary adjustments, the
greater the responsiveness of quantity supplied to
price changes
 Let’s Recall!
In the following video we have seen:
• Income elasticity of demand (YED)
* Interpretations of YED
* Applications of YED- impacts on producers and the
economy
• Price elasticity of supply (PES)
* Degrees of PES
* Determinants of PES
* Applications of PES- primary and manufactured
goods
 Looking Ahead!
In the next video we’ll be looking at:
• Introduction to indirect taxes
• The reasons behind imposing them
• Impacts on market outcomes
• Consequences imposed on various stakeholders
• Welfare effects of indirect taxes
 Thanks for watching!

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