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10 Income Elasticity: Income Elasticity of Demand (YED) Measures The Responsiveness of Demand To A Change in Income

The document discusses income elasticity of demand and how it can be useful for manufacturers. It defines income elasticity of demand as measuring the responsiveness of demand to a change in income. It then defines four types of goods based on their income elasticity: normal goods (YED > 0), luxury goods (YED > 1), necessities (YED < 1), and inferior goods (YED < 0). The document notes that knowledge of income elasticity allows manufacturers to plan sales and allocate resources efficiently to maximize profits by focusing on goods that have positive income elasticity as demand for them increases with income.

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Adeeba iqbal
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59 views2 pages

10 Income Elasticity: Income Elasticity of Demand (YED) Measures The Responsiveness of Demand To A Change in Income

The document discusses income elasticity of demand and how it can be useful for manufacturers. It defines income elasticity of demand as measuring the responsiveness of demand to a change in income. It then defines four types of goods based on their income elasticity: normal goods (YED > 0), luxury goods (YED > 1), necessities (YED < 1), and inferior goods (YED < 0). The document notes that knowledge of income elasticity allows manufacturers to plan sales and allocate resources efficiently to maximize profits by focusing on goods that have positive income elasticity as demand for them increases with income.

Uploaded by

Adeeba iqbal
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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10 INCOME ELASTICITY

A demand curve for good shifts if income changes, but the direction and extent of the shift depend on the income
elasticity of demand for that good.

Income elasticity of demand (YED) measures the responsiveness of demand to a change in income.

A normal good has a positive YED > 0. As income rises, demand for a normal good rise. For example, chocolate,
TVs and mobile phones etc.

A luxury good has a positive YED > 1. As income rises, demand for the luxury good rises a lot. The percentage
change in demand is greater than the percentage change in income. For example, top-brands including Mercedes
cars, Nike trainers, Dolce and Gabbana perfumes etc.

A necessity has a positive YED < 1. As income rises, demand for the necessity rises by only a small amount. The
percentage change in demand is less than the percentage change in income. For example, milk, bread and water.

An inferior good has a negative YED < 0. As income rises, demand for an inferior good fall. For example,
‘economy’ food in supermarkets.

Usefulness of knowledge of price elasticity of demand:


A manufacturer would find his knowledge of PED for his commodity very useful in adapting pricing policies and
taking business decisions. In other word a business cannot fix its profit maximizing price unless it has a knowledge
of PED. Thus, if the firm’s product face an elastic demand, then the businessmen would be able to maximize his
net revenue if he lowers the price. This is because a small decrease in price will lead to more than proportionate
increase in quantity demanded, which ultimately will increase his total revenue. It will be a mistake to increase
the price if demand is elastic since revenue will fall.
Evaluation: However, the firm cannot only rely on the concept of PED to increase revenue. The data of PED do
not reveal absolute truths. They are based on survey carried out on small sample of customer. Hence, they cannot
be completely accurate. Moreover, the concept of PED is calculated on basis of all other factors affecting demand
remain constant. But, in practice demand keeps changing due to changes in other factors too.

Usefulness of knowledge of income elasticity of demand:


Knowledge of income elasticity of demand is useful to a manufacturer as it helps him to plan his sales and
allocate resources more efficiently in order to maximize profit. Indeed, the producer must take into account the
economic situation of the country. If the country experiences economic growth, national income will rise, and
this rise in income will be shared among most households. As the latter finds their income increasing, they
increase their demand for many commodities. Hence, the producer will be well advised to allocate resources
in the production of those commodities for which income elasticity of demand is positive (normal goods). For
those engaged in the production of goods with negative income elasticity(inferior goods), this will mean a
declining demand for their product. Thus, this producer will have to restructure their business by sifting to
normal goods. However, even products with positive income elasticity, there is a great variability of response.
For instance, with commodities for which income elasticity of demand is inelastic, although demand may
rise with income, it might not rise faster. The booming industries tend to be those making products which are
highly income elastic. On the other hand, a downturn in national income may well mean a rapid decline in the
demand for positive income elasticities. Hence, only in such an economic situation should inferior goods be
promoted.
Activity 1:
In 2016, average incomes in a country rose from €30 000 to €32 400. This caused a change in the quantity
demanded for two particular products: X and Y. Total annual quantity demanded for product X rose from 24
million units to 30 million units. However, the quantity demanded for product Y fell from 10 million units to 9
million units.

1 Calculate the income elasticity of demand for products X and Y.


2 Are the two products (X and Y) income elastic or income inelastic?
3 Are the two products X and Y normal or inferior? Give an explanation in your answer.

Activity 2:

EFFECT ON TOTAL REVENUE OF A PRICE INCREASE WHEN DEMAND IS INELASTIC

If a business has inelastic demand for one of its products, it knows that a price increase will increase revenue. For
example, if price elasticity of demand (PED) = -0.8 and current demand is 2 million units, a 5% price increase
from US$20 to US$21 will increase revenue. The following calculations prove this.

The change in demand is give in by:


% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
PED =
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝

Therefore:
% 𝑐𝑐ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑖𝑖𝑖𝑖 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
-0.8 =
5%

-0.8 × 5% = % change in demand

-4% =change in demand

Therefore the new level of demand following the price increase will be:
= Previous demand - 4%
= 2 million - (4% × 2 million)
= 2 million - 80 000
= 1 920000

The change in total revenue is given by:


When price is US$20 TR = US$20 × 2 million = US$40 million
When price is US$21 TR = US$21 × 1 .92 million = US$40.32 million

Therefore, the price increase has resulted in a rise in total revenue of US$320 000.

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