2.2.4 Income elasticity of demand (YED)

Question 1

Income elasticity of demand

Answer 1

Measures the change in QD when incomes change

Question 2

Normal goods

Answer 2

Have positive YED → rise in income will lead to an increase in quantity demanded

Question 3

Inferior goods

Answer 3

Negative YED → demand rises as incomes fall

• Not of a poor quality but its functions is less attractive than a more expensive alternative (eg public transport, savers food, council houses )
• Influenced by attitudes and incomes, and with uneven income distribution, relative luxuries to some may seen as inferior goods to others

Question 4

YED

Answer 4

• Demand affects income.
• For most goods (normal) an increase increased QD. YED measures how much QD changes when income changes → measures the responsiveness of of demand to changes in income

Question 5

calculating YED

Answer 5

percentage change in QD/ percentage change in incomen

Question 6

interpreting YED

Answer 6

• A positive sign denotes a normal good (QD increases as income increases)
• A negative sign denotes an inferior good (QD decreases as income increases)
• YED>1 –> income elastic good (income change causes a larger QD change)
• YED=1 –> unitary income elastic good (income change is proportionate to QD change)
• YED<1 —> income inelastic good (income change causes a smaller QD change)

Question 7

cross elasticity

Answer 7

Responsiveness of demand of one good to changes in price of another good → substitute or a complement

• A positive answer denotes a substitute: there is a positive relationship between the two
• A negative answer denotes a complementary good: there is an inverse relationship between the two

Question 8

4 factors affecting YED

Answer 8

1. luxuries
2. habits
3. share of spent income
4. confidence and expectations

Question 9

luxuries

Answer 9

• Luxuries tend to be income elastic and have positive and high YED values
• If incomes and spending powers rise, demand for luxuries (holidays, sports cars) tend to rise at a faster rate → people who couldn’t buy them before now have the money to
• Necessities are income inelastic and have a low positive YED value
• A fall in income causes a slight decrease in demand as consumers see little alternative to that necessity and will cut down spending elsewhere (eg milk)
• Luxuries and necessities vary between individuals and is down to consumer preference

Question 10

habits

Answer 10

• Habits are slow to change → many foodstuffs have low YED (eg tea bags)
• Relatively inelastic as many buy them now but elastic when loose leaf tea was preferred

Question 11

share of income spent

Answer 11

Housing → as real incomes fell, demand for buying houses fell → House prices have risen but incomes have fallen

Question 12

confidence and expectations

Answer 12

• A drop in income (seen as a blip) has little demand on consumer demand for most products
• A loss of confidence and predictions that income will keep falling (recession in 2009) → people cut back on many luxuries, and demand for other useful items (thermos and flasks to bring lunch rather than buying it) increases

Question 13

significance of YED to business

Answer 13

• Changes in individual incomes have little impact on demand and businesses, but only changes in income across the economy
• Higher incomes have grown the fastest out of all incomes for the population and firms selling luxuries have benefitted the most

Question 14

recession and YED

Answer 14

• Lost output and slow growth that followed the 2008 financial crisis signaled recession
  Technically in recession if outputs falls for 6 months → 2009, and recovery was very slow
• Majority of the working population had lower real income for years then in 2014 earnings rose again
  If incomes and purchasing power rises again, a boom may develop meaning strong economic growth

Question 15

demand elasticity and business

Answer 15

• Many firms have some products with considerable income Elast of D, positive or negative
• Affected by the long term trend of rising incomes and by shorter term recessions and booms
• Awareness of YED can allow them plan for anticipated demand
• Rises in income: good for luxury businesses
• Anticipating consumers use cheaper options in a recession allow firms to cater to them and ensure their business
• Firms that combine awareness of their products price elasts and knowledge of income trends can take action → greatest on inferior goods with negative YED due to gradual increases in income
• Luxury producers can plan to increase supply as income rises and can find new extremes of luxury for conspicuous consumers who see earlier purchases becoming less exclusive and high end (newer cars, tesla etc)

Question 16

YED and time

Answer 16

• As time ensues and income increases, consumers expect more and better
• Some products become inferior, and consumers switch to better alternatives → producers either decline or diversify into products with positive YED (normal goods)