INCOME ELASTICITY OF DEMAND
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INCOME ELASTICITY OF DEMAND (YED): Measures the responsiveness of demand to change in income
The income elasticity of demand (YED) provides two pieces of information:
1) Sign of YED: Positive (Normal Good) or Negative (Inferior Good)
Normal Good ( YED > 0 ) : Quantity demanded and income changes in the same direction
Inferior Good ( YED < 0 ) : Quantity demanded and income changes in the opposite direction
2) Absolute Value of YED: Less than one (Necessities) or Greater than one (Luxuries)
Necessities ( YED < 1 ) : Quantity demanded is relatively unresponsive to income
Luxuries ( YED > 1 ) : Quantity demanded is relatively responsive to income
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NOTE: Change in income refers to the change in consumer income
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INCOME ELASTICITY OF DEMAND (YED): NORMAL GOOD
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NORMAL GOOD: Good for which demand increases as consumer income increases (most goods are normal goods)
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Normal Good ( YED > 0 ) : Quantity demanded and income changes in the same direction
A good is normal if the income elasticity of demand (YED) is a positive value:
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As the demand for a normal good varies directly with income, quantity demanded and income changes in the same direction:
If consumer income increases, the quantity demanded of normal good increases; hence, a positive change in quantity demanded over a positive change in income will produce a positive value
Alternatively, if consumer income decreases, the quantity demanded of normal good decreases; hence, a negative change in quantity demanded over a negative change in income will produce a positive value
Thus, the income elasticity of demand (YED) of a Normal Good will be a positive value
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Example: Clothes
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Suppose an individual’s income increases from $800 per month to $1000 per month, and their
purchase of clothes increases from $100 to $140 during this period. Calculate the income elasticity
of demand.
As the value of YED is 0 < 1.6, Clothing is a Normal Good
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INCOME OF DEMAND (XED): INFERIOR GOODS
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INFERIOR GOOD: Good for which demand decreases as consumer income increases (example of inferior good includes bus rides, second-hand clothes, and used cars)
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Inferior Good ( YED < 0 ) : Quantity demanded and income changes in the opposite direction
A good is Inferior if the income elasticity of demand (YED) is a negative value:
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As the demand for a normal good varies inversely with income, quantity demanded and income changes in the opposite direction:
If consumer income increases, the quantity demanded of inferior good decreases; hence, a negative change in quantity demanded over a positive change in income will produce a negative value
Alternatively, if consumer income decreases, the quantity demanded of inferior good increases; hence, a positive change in quantity demanded over a negative change in income will produce a negative value
Thus, the income elasticity of demand (YED) of an Inferior Good will be a negative value
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Example: Cheese sandwiches
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Suppose an individual’s income increases from $1000 per month to $1200 per month, and their
purchase of cheese sandwiches decreases from 15 to 10 during this period. Calculate the income
elasticity of demand.
As the value of YED is 0 > - 1.65, Cheese Sandwiches are an Inferior Good
INCOME ELASTICITY OF DEMAND (YED): NECESSITIES
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NECESSITIES: An essential good
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Necessities ( YED < 1 ) : Quantity demanded is relatively unresponsive to income
A good is categorized as necessity if the income elasticity of demand (YED) is less than one; hence, demand is income inelastic:
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As necessities are essential, consumers have no choice but to consume the good regardless of income
For this reason, the demand for necessities is relatively unresponsive to income, with a change in income leading to a smaller percentage change in quantity demanded
Hence, the demand for necessities is income inelastic
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NOTE: Whether a good is a necessity or a luxury will depend on the income level of consumers; hence,
as income increases, certain items that used to be luxuries become necessities
INCOME ELASTICITY OF DEMAND (YED): LUXURIES
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LUXURIES: A non-essential good
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Luxuries ( YED < 1 ) : Quantity demanded is relatively responsive to income
A good is categorized as a luxury if the income elasticity of demand (YED) is greater than one; hence, demand is income elastic:
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As luxuries are non-essential, consumers have a choice in whether to consume the good
For this reason, the demand for luxuries is relatively responsive to income, with a change in income leading to a larger percentage change in quantity demanded
Hence, the demand for luxuries is income elastic
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NOTE: Whether a good is a necessity or a luxury will depend on the income level of consumers; hence,
as income increases, certain items that used to be luxuries become necessities
INCOME ELASTICITY OF DEMAND AND THE ECONOMY
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As countries undergo economic growth, the real income of consumers increases, resulting in a growing demand for goods and services; hence, producers interested in producing in an expanding market may want to know the income elasticity of demand (YED) of various goods and services:
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The lower the YED of a good or service, the smaller the expansion of the market in the future
The higher the YED of a good or service, the greater the expansion of the market in the future
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Primary Products
As primary products are necessities with no close substitutes, consumers cannot refuse to consume the good and cannot switch to an alternative substitute; hence, the demand for primary products is relatively unresponsive to income and is thus income inelastic (relatively low YED):
During periods of economic growth, the rise in consumer income will lead to a smaller percentage increase in quantity demanded, resulting in a slow market expansion of the primary sector; producers are therefore worse off as they cannot increase sales and total revenue
Alternatively, during periods of economic contraction, the fall in consumer income will lead to a smaller percentage decrease in quantity demanded, resulting in a slow market contraction of the primary sector; producers are therefore better off as they avoid loss in sales and total revenue
Manufactured Products
As manufactured products are luxuries with close substitutes, consumers can refuse to consume the good and can switch to an alternative substitute; hence, the demand for primary products is relatively responsive to income and is thus income elastic (relatively higher YED):
During periods of economic growth, the rise in consumer income will lead to a larger percentage increase in quantity demanded, resulting in rapid market expansion of the manufacturing sector; producers are therefore better off as they can increase sales and total revenue
Alternatively, during periods of economic contraction, the fall in consumer income will lead to a larger percentage decrease in quantity demanded, resulting in a rapid market contraction of the manufacturing sector; producers are therefore worse off as they incur large losses in sales and total revenue
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Services
As services are often luxuries with many close substitutes, consumers can refuse to consume the service and can switch to an alternative substitute; hence, the demand for services is relatively responsive to income and is thus more income elastic (high YED):
During periods of economic growth, the rise in consumer income will lead to a larger percentage increase in quantity demanded, resulting in a rapid market expansion of the tertiary (service) sector; producers are therefore better off as they can increase sales and maximize total revenue
Alternatively, during periods of economic contraction, the fall in consumer income will lead to a larger percentage decrease in quantity demanded, resulting in a rapid market contraction of the tertiary sector; producers are therefore worse off as they incur large losses in sales and total revenue
INCOME ELASTICITY OF DEMAND AND THE ECONOMY
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As countries undergo economic growth, the relative importance of sectors changes over time, with the respective share of output in economy shifting from the primary sector, to the manufacturing sector, and lastly, to the service sector:
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Primary Products
The primary sector produces primary products involving agriculture, forestry, fishing, and extractive industries
As the demand for primary products is income inelastic, during periods of economic growth, the rise in consumer income will lead to a smaller percentage increase in quantity demanded; hence, the demand for primary output grows more slowly than the growth in income
Thus, with economic growth, the primary sector becomes less important and the share of primary output in the economy shrinks
Manufactured Products
The manufacturing sector produces manufactured goods
As the demand for manufactured products is income elastic, during periods of economic growth, the rise in consumer income will lead to a larger percentage increase in quantity demanded; hence, the demand for manufactured output grows faster than the growth in income
Thus, with economic growth, the manufacturing sector becomes more important and replaces the primary sector
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Services
The service sector provides services such as entertainment, travel, and banking
As the demand for services is more income elastic, during periods of economic growth, the rise in consumer income will lead to a significantly larger percentage increase in quantity demanded; hence, the demand for services grows significantly faster than the growth in income
Thus, with economic growth, the service sector becomes more important and replaces the primary and manufacturing sector
NOTE: Over time, the share of agricultural output in the economy shrinks, while the share of manufactured output grows; with continued growth, the services sector expands at the expense of both primary sector and manufacturing
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