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Tutor2u - Income Elasticity of Demand

The link between income and demand is explored when we cover income elasticity of demand. The most important distinction to make in this section is between normal and inferior products. Please also be clear on the difference between a normal necessity and a normal luxury. The coefficient of income elasticity is important for businesses because it helps them to forecast, other factors remaining the same, how demand for their goods and services will be affected by changes in the real incomes of consumers as an economy moves through the various stages of a business cycle. Producers of inferior goods tend to do well when an economy is in recession or when real wages are falling!

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Tutor2u - Income Elasticity of Demand

  1. 1. How Markets Work – Income Elasticity of Demand (YED)
  2. 2. How Markets Work Income Elasticity of Demand
  3. 3. What is Income Elasticity of Demand? • The formula for calculating income elasticity of demand (YED) is • % change in quantity demanded / % change in real income • With income elasticity, we distinguish between the following: 1. Normal goods – they have a positive income elasticity 2. Luxury goods – where the income elasticity > +1 3. Necessities – here the income elasticity >0 and <+1 4. Inferior products – these have negative income elasticity • Inferior goods are counter cyclical goods – products whose demand varies inversely to the macroeconomic cycle – demand rises in a downturn Income elasticity of demand (YED) shows how responsive the demand for a product is to a change in (real) income
  4. 4. Normal Necessities and Normal Luxuries When YED is positive, a product is a normal good • If, following an increase in income, more of the good is demanded, then the good is a ‘normal’ good. • Normal goods have a positive YED, i.e. YED > 0 • Normal necessities: (income inelastic) – These products have a low but positive income elasticity – typically necessities such as milk and fruits • Normal luxuries: (income elastic) – These products have a high and positive income elasticity – typically these are higher-end products considered as a luxury by the relevant group of consumers • What is considered a necessity and a luxury is contextual – i.e. it depends on the circumstances of the consumers involved
  5. 5. Inferior Goods Inferior goods have a negative income elasticity of demand • If, following an increase in income, less of the good is consumed, then the good is an inferior good. • Such goods have a negative YED, i.e. YED < 0 • When real incomes are rising during a period of economic growth, then the demand for inferior goods will fall causing an inward shift of the demand curve • When real incomes are falling during a period of recession or (more generally) if wages are rising more slowly than prices, the demand for inferior goods will rise. • Inferior goods are sometimes called “counter-cyclical” products
  6. 6. Examples of Luxury and Inferior Goods Knowledge of YED is important for a firm, since it can estimate how demand for its products will change following a change in incomes Luxury chocolates Exclusive resorts Business class travel Fine wines and dining Own label discounters Urban bus transport Cigarettes Economy class travel
  7. 7. Household Spending on Tobacco – By Income Decile Tobacco is widely regarded as an inferior good • Weekly spending on cigarettes is highest for the 4th income decile group. • There is some evidence that households in the richest 30% of income spend less on tobacco although the effects are not very large. • The poorest 10% of the population spend more on cigarettes than the richest 10% • But there is no uniform picture on the link between income and weekly spending on cigarettes. Average weekly household expenditure on cigarettes in UK in 2013, by gross income decile group (£s) Lowest ten per cent 2.50 Second decile group 2.70 Third decile group 4.00 Fourth decile group 4.70 Fifth decile group 4.10 Sixth decile group 3.90 Seventh decile group 4.20 Eighth decile group 3.80 Ninth decile group 2.90 Highest ten per cent 2.30
  8. 8. Get help from fellow students, teachers and tutor2u on Twitter: @tutor2u_econ
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