Income Elasticity of Demand (YED)

YED definition

is a measure of responsiveness of demand to change in income

What does a YED value between –1 and +1 indicate?

Demand is income inelastic.

What does a YED value lower than –1 or higher than +1 indicate?

Demand is income elastic.

What is the YED value for normal goods?

YED > 0 (positive YED).

How does demand for normal goods change with income?

Demand increases as income rises.

What is the YED value for luxury goods?

YED > +1.

Are luxury goods income elastic or inelastic?

Income elastic (demand is very sensitive to income changes).

Give an example of a luxury good.

Designer handbags, sports cars

What is the YED range for necessities?

0 < YED < +1

Are necessities income elastic or inelastic?

Income Elastic

What is the YED value for inferior goods?

YED < 0 (negative YED)

How does demand for inferior goods change with income?

Demand decreases as income rises.

Give an example of an inferior good.

Instant noodles, supermarket own-brand products.

What is another name for inferior goods?

Counter-cyclical goods (because demand rises during economic downturns).

What are the two determinants of YED?

1. Whether good is necessity or luxury

2. Level of income of consumer

How does consumer income affect demand for necessities and luxuries?

At higher standards of living, extra income is spent more on luxuries since necessities are already satisfied.

How do lower-income households allocate their spending?

They spend more on necessities rather than luxuries

What happens to YED for necessities as income rises?

YED for necessities moves towards 0 because consumers are satisfied with the amount they can buy.

How does spending behaviour change as income increases?

Consumers are more likely to spend on luxuries.

YED relevance for firms

Standards of living:

• Wealthier countries are more likely to have consumers with more disposable income and purchasing power , hence firms will produce luxury goods that meets consumer's needs

• As standards of living increases, we expect to see increased demand for luxury goods and movement way from inferior goods.

What are the possible Evals for YED?

• Problems being estimates & ceteris paribus potentially not holding & weakens YED relevance to firms

• These estimates require accurate forecasts of future income to exist

• Even if firms has accurate YED - future demand can only be predicted if firms know what happens to consumer income in future

• Macro predictions are difficult to make - Weakening value of YED estimates to firms

What is the formula for calculating YED (Income Elasticity of Demand)?

YED = % change in quantity demanded / % change in income.

Economic Cycle:

• When economy is recovering & leading into a boom, disposable incomes increase, therefore they spend greater proportion on necessities then luxuries

• When economy is declining leading into a slump , decreasing disposable income . - Therefore consumers spend less on luxuries moving to necessities then inferior goods.

Firms will identify the state of economy and produce goods & service to meet demand.