Income Elasticity of Income Elasticity of DemandDemand

DP EconomicsDP Economics

Key IssuesKey Issues The meaning of income elasticity of The meaning of income elasticity of

demanddemand Measuring income elasticityMeasuring income elasticity Normal goodsNormal goods Luxury goodsLuxury goods Inferior GoodsInferior Goods Income elasticity of demand and the Income elasticity of demand and the

economic cycleeconomic cycle

Income Elasticity of DemandIncome Elasticity of Demand Income elasticity of demand (YED) measures the Income elasticity of demand (YED) measures the

responsiveness of quantity demanded to changes in responsiveness of quantity demanded to changes in realreal income. income.

YED = %YED = %ΔΔ demand / % demand / %ΔΔ in income in income

Example: Example:

A rise in consumer real income of 7% leads to an A rise in consumer real income of 7% leads to an 9.5% rise in demand for pizza deliveries.9.5% rise in demand for pizza deliveries.

The income elasticity of demand:The income elasticity of demand:

= 9.5/ 7 = +1.36= 9.5/ 7 = +1.36

EffectEffect Income elasticity Income elasticity coefficient coefficient

Classification of Classification of good good

A proportionately A proportionately larger change in larger change in

the quantity the quantity demandeddemanded

>1 >1 Luxury good Luxury good

A proportionately A proportionately smaller change in smaller change in

the quantity the quantity demanded demanded

<1 <1 NormalNormal

A negative change A negative change in the quantity in the quantity

demanded demanded

<0 <0 Inferior good Inferior good

Inferior GoodsInferior Goods Inferior goods have a negative income Inferior goods have a negative income

elasticity of demand. Demand falls as elasticity of demand. Demand falls as income risesincome rises

For example:For example: A 12% rise in incomes leads to a 3% A 12% rise in incomes leads to a 3% decreasedecrease

in the demand for bus travelin the demand for bus travel The income elasticity of demand = -3/+12The income elasticity of demand = -3/+12 Yed = -0.25Yed = -0.25

Different Types of Goods and Different Types of Goods and their Income Elasticitytheir Income Elasticity

LuxuryLuxury Normal NecessityNormal Necessity Inferior GoodInferior Good

Air travelAir travel Fresh vegetablesFresh vegetables Frozen vegetablesFrozen vegetables

Fine winesFine wines Instant coffeeInstant coffee Cheep CigarettesCheep CigarettesLuxury chocolatesLuxury chocolates Natural cheeseNatural cheese Processed cheeseProcessed cheesePrivate educationPrivate education Fruit juiceFruit juice MargarineMargarinePrivate health carePrivate health care Spending on Spending on

utilities utilities Tinned meatTinned meat

Antique furnitureAntique furniture Shampoo / Shampoo / toothpaste / toothpaste / detergentsdetergents

Value “own-brand” Value “own-brand” breadbread

Designer clothesDesigner clothes Rail travelRail travel Bus travelBus travel

Income Elasticity of Demand for Income Elasticity of Demand for ChocolateChocolate

Total consumption Total consumption USA +0.79 USA +0.79 Germany +0.39 Germany +0.39 United Kingdom +0.44 United Kingdom +0.44 France +0.60 France +0.60 Japan +0.1 Japan +0.1 Switzerland +1.06 Switzerland +1.06

Reference: Henri Jason Trends in cocoa and chocolate Reference: Henri Jason Trends in cocoa and chocolate consumption with particular reference to developments in the consumption with particular reference to developments in the major markets. Malaysian International Cocoa Conference, major markets. Malaysian International Cocoa Conference, Kuala Lumpur, 20-21 October 1994 (ICCO, ED(MEM) 686)Kuala Lumpur, 20-21 October 1994 (ICCO, ED(MEM) 686)

Income Elasticity and the Income Elasticity and the Demand for Airline TravelDemand for Airline Travel

Demand for air travel has a positive income elasticity of Demand for air travel has a positive income elasticity of demanddemand

The industry is cyclicalThe industry is cyclical During an upturn, demand rises for business and During an upturn, demand rises for business and

leisure travelleisure travel During a recession, the demand tails awayDuring a recession, the demand tails away

In the long run, there is a positive relationship between In the long run, there is a positive relationship between real GDP per capita and the demand for air travelreal GDP per capita and the demand for air travel

Income elasticity will vary according to the type of air travel Income elasticity will vary according to the type of air travel E.g. difference between low-cost “no-frills” and higher E.g. difference between low-cost “no-frills” and higher

priced scheduled services on low-haul flightspriced scheduled services on low-haul flights

Income Per Capita and Airline Income Per Capita and Airline Travel by CountryTravel by Country

Bulgaria

Nigeria Ukraine

Belarus

Ecuador

Romania Lithuania

Tunisia Brazil

Colombia Hungary

S. Africa

Mexico Venezuela

Denmark Norw ay Japan

Singapore

Hong Kong China

US Sw itzerland Australia

New Zealand

UK Netherlands Canada

Italy

Austria Malaysia

Saudi Arabia Greece

Korea Rep

Chile

Portugal

Spain

Ireland

Israel

Sw eden Finland

Germany

France Belgium

Slovenia Uruguay

Czech Rep Argentina

Lebanon Dominican Rep

Thailand Panama

Costa Rica

Kenya Sri Lanka

Philippines Peru

Cote D'Ivoire

Pakistan

Vietnam Cameroon

India

Bangladesh

China Algeria Iran

Poland Syria

Turkey Zimbabw e

Paraguay

Croatia

10

100

1000

10000

100000

0 5000 10000 15000 20000 25000 30000 35000

GNP per capita ($ PPP)

ASK

(000

) per

cap

ita

Significance of Income Elasticity Significance of Income Elasticity of Demandof Demand

High Income ElasticityHigh Income Elasticity Demand is sensitive to changes in real incomesDemand is sensitive to changes in real incomes Demand is therefore cyclical – in an economic Demand is therefore cyclical – in an economic

expansion, demand will grow strongly. In a expansion, demand will grow strongly. In a recession demand may fallrecession demand may fall

Can be difficult for businesses to accurately Can be difficult for businesses to accurately forecast demand and make capital investment forecast demand and make capital investment decisionsdecisions

Significance of Income Elasticity Significance of Income Elasticity of Demandof Demand

Low Income ElasticityLow Income Elasticity Demand is more stable during fluctuations in the Demand is more stable during fluctuations in the

economic cycle than high YEDeconomic cycle than high YED Over time, the share of consumer spending on Over time, the share of consumer spending on

inferior goods and normal necessities tends to inferior goods and normal necessities tends to declinedecline

Long run – businesses need to invest in / focus Long run – businesses need to invest in / focus on products with a higher income elasticity of on products with a higher income elasticity of demand if they want to increase total profitsdemand if they want to increase total profits