Chapter 8- Income Elasticity of Demand

Question 1

Income Elasticity of Demand

Answer 1

The extent to which demand is affected by changes in income.

= %change in quantity demanded/%change in income

Considering two products A and B: if income rise by 10% and demand for product A rises by 25%, the change in demand is proportionately greater than the change in income – economists would say that the demand for product A is income elastic

In contrast if demand for product B only rose by 5%, economists would say that demand for a product is income inelastic – this is because the percentage increase in demand is proportionately less than the percentage increase in income.

Question 2

Two factors that influence the income elasticity of demand:

Answer 2

• Luxury goods- if a product is income elastic then when income
rises, so does the demand for the product. Products would
include- TV, cars, computers, phones, foreign holidays, going out
to restaurants etc.

• Necessity goods- if a product is income inelastic then as income
rises the demand for the product will increase a little or not at all.
Products could include- necessities such as bread, milk and
butter.

Question 3

The significance of income elasticity of demand to the business:

Answer 3

• Business selling goods with high income elasticity- Demand for
goods that are sensitive to changes in income (e.g. highly income
elastic) is often cyclical = if economy is growing, demand will
increase for luxury goods, however if economy is in a recession,
then demand for that good will fall.

• Businesses selling goods with low income elasticity- Demand for
income elastic good tends to be more stable during different
phases of the business cycle.

• Production planning- Business can respond to income changes.
Goods that are income elastic demand, can be produced more if
income is predicted to rise. On the other hand, if recession is
expected the business will plan to cut output because incomes
are likely to fall.

• Product Switching - Some manufacturers have flexible resources
and can switch from the production one good to another. E.g.
manufacturer of plastic could change from household goods to
plastic toys if demand for them was income elastic.

Question 4

Interpretation of the numerical values of income elasticity of demand

Answer 4

If the data shown is greater than 1, then this in income elastic.
If the data shown is less than 1, this is income inelastic.

Normal goods, where an increase in income results in an increase in demand, the value of income elasticity will be positive.

Inferior goods, where an increase in income results in a decrease in demand, vale of income elasticity will be negative.