Income Elasticity

Income Elasticity of Demand (YED)

Definition of Income Elasticity of Demand

  • Income elasticity of demand (YED) measures how the quantity demanded for a good responds to a change in consumer income.
  • It indicates the responsiveness of quantity demanded for a good to changes in income.
  • The relationship analyzed is between changes in quantity demanded for a particular good and changes in income levels.

Formula for Income Elasticity of Demand

  • The formula used to calculate income elasticity of demand is:
    YED = \frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in income}}
  • Note: Negative signs in the calculations should NOT be disregarded.

Calculation of Percentage Changes

  • To calculate the percentage change in quantity demanded and income, the following formulas are utilized:

    1. Percentage Change in Quantity Demanded ($% QD$):
      % QD = \frac{(Qd2 - Qd1) \times 100}{\frac{Qd1 + Qd2}{2}}
    • Where:
      • $Qd1$ = the original quantity demanded
      • $Qd2$ = the new quantity demanded
    1. Percentage Change in Income ($% Y$):
      % Y = \frac{(Y2 - Y1) \times 100}{\frac{Y1 + Y2}{2}}
    • Where:
      • $Y1$ = the original income
      • $Y2$ = the new income

Interpretation of Income Elasticity of Demand

  • Greater than 1 (YED > 1):

    • Elastic Income
    • Indicates a high sensitivity in the quantity demanded for a good in response to income changes.
    • These goods are classified as luxury goods, which are purchased more as income increases.

  • Between 0 and 1 (0 < YED < 1):

    • Inelastic Income
    • Occurs when the quantity demanded changes by a smaller percentage than the change in consumers' income.
    • These goods are typically essential goods or basic needs.

  • Equal to 0 (YED = 0):

    • Perfectly Inelastic Income
    • A situation where a change in income has no effect on the quantity demanded.
    • Demand remains unchanged regardless of income level.

  • Equal to 1 (YED = 1):

    • Unitary Income
    • This denotes that the percentage change in quantity demanded is exactly equal to the percentage change in income.
    • There is a direct proportional relationship between income and demand.

Classification of Goods Based on Income Elasticity

  • Normal Goods:

    • Demand increases as consumer income rises.
    • The quantity demanded rises with an increase in income.
    • Example: Units of air-conditioning increase as consumer income increases.

  • Inferior Goods:

    • Demand decreases when consumer income increases, while demand increases when consumer income decreases.
    • Example: Demand for electric fans decreases with an increase in consumer income while increasing when income decreases.

Further Analysis of Normal and Inferior Goods

  • Positive Income Elasticity (YED > 0):

    • Indicates normal goods where demand rises as consumer income rises.
    • As income rises, individuals tend to spend less proportionately on inexpensive goods as they can afford more expensive alternatives.
    • If YED remains positive, it shows consumers' persistent preference for normal goods even if income changes.

  • Negative Income Elasticity (YED < 0):

    • Indicates inferior goods where demand decreases as income increases and increases with a decrease in income.
    • When income decreases, demand for inferior goods tends to rise as consumers switch to less expensive alternatives.
    • The persistence of negative YED despite increasing income reflects a strong consumer preference for affordability.

Example Calculation of Income Elasticity

  • Context: Filicity's monthly salary and consumption patterns
    • Monthly salary: ₱5,000
    • Original consumption of chicken: ₱1,000
    • New income after an increase: ₱7,500
    • New consumption: ₱2,000

Step 1: Calculate Percentage Change in Demand

  • % QD = \frac{(2000 - 1000) \times 100}{\frac{1000 + 2000}{2}}
  • This simplifies to:
    • Numerator: (₱1,000) × 100 = ₱100,000
    • Denominator: (₱1,500) = ₱1,500
  • Thus, % QD = \frac{100000}{1500} = 66.67 \approx 67 ext{%}

Step 2: Calculate Percentage Change in Income

  • % Y = \frac{(7500 - 5000) \times 100}{\frac{5000 + 7500}{2}}
  • This simplifies to:
    • Numerator: (₱2,500) × 100 = ₱250,000
    • Denominator: (₱6,250) = ₱6,250
  • Thus, % Y = \frac{250000}{6250} = 40\text{%}

Step 3: Determine The Type of Income Elasticity

  • YED Calculation:
  • Using previous percentage changes:
    YED = \frac{67}{40} = 1.675 \approx 1.68
  • This indicates elastic income elasticity: as income increases, consumption increases significantly.

Step 4: Classifying Demand Type

  • The demand for chicken in this context is identified as a normal good since Filicity increased her consumption with an increase in income.
  • Explanation: As Filicity's income increased, she could afford to purchase more chicken, reflecting a direct relationship between income and demand.

Demand Schedule Example

MonthIncome (₱)Quantity Demanded (Chicken Consumed)
1st month₱ 5,000₱ 1,000
2nd month₱ 7,500₱ 2,000

Conclusion

  • Income elasticity of demand is a critical concept in understanding consumer behavior, especially how demand shifts based on income changes.
  • The classification between normal and inferior goods is significant for economic analysis and predictive modeling in consumer goods markets.