Unit 1 - The Market System: Chapter 10: Income Elasticity

Understand the definition and calculation of income elasticity of demand.
Understand how to interpret numerical values of income elasticity of demand.
Understand the significance of price and income elasticities of demand to businesses and the government regarding the imposition of taxes and subsidies, and changes in income.

Income elasticity of demand: Measures the responsiveness of demand to a change in income.

Income elasticity of demand = $\frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in income}}$
Example: If income rises by 10%:
- Product A's quantity demanded rises by 25%: Income elasticity = $\frac{25\%}{10\%} = 2.5$
- Product B's quantity demanded rises by 5%: Income elasticity = $\frac{5\%}{10\%} = 0.5$

Luxuries are goods that consumers purchase when they can afford them.
Spending on luxuries is discretionary expenditure (non-essential spending).
Demand for luxury goods is income elastic (greater than 1 or less than -1).
Examples: air travel, satellite television, designer clothing, leisure and tourism.
Demand for imported goods is often income elastic.

For normal goods, an increase in income leads to an increase in quantity demanded.
The value of income elasticity will be positive.
In the previous example, Products A and B are normal goods.

For inferior goods, an increase in income leads to a decrease in quantity demanded.
The value of income elasticity will be negative, indicating an inverse relationship between income and quantity demanded.
Examples: Goods bought at discount stores.

Price elasticity informs businesses about the effect of price changes on total revenue.
Knowing how a price change affects total revenue is valuable.

If demand is inelastic, a price increase will increase revenue.
Example: PED = -0.8, current demand = 2 million units, price increase from US$20 to US$21.
The change in demand is calculated using: $PED = \frac{\% \text{ change in demand}}{\% \text{ change in price}}$
$-0.8 = \frac{\% \text{ change in demand}}{5\%}$
$-0.8 \times 5\% = \% \text{ change in demand}$
$-4\% \text{ change in demand}$
New level of demand: 2 million - (4% x 2 million) = 1.92 million.
Total Revenue (TR) when price is US$20: US$20 x 2 million = US$40 million.
Total Revenue (TR) when price is US$21: US$21 x 1.92 million = US$40.32 million.
The price increase resulted in a revenue rise of US$320,000.
In conclusion, firms can predict the effect on total revenue of any price changes they make.
A price reduction will increase total revenue if demand is elastic. This explains why many rail companies charge much-reduced prices for 'off-peak' rail travel.

Firms are interested in income elasticity because changes in income affect product demand.
Knowing income elasticity allows firms to respond to predicted income changes.
Firms with flexible resources can switch production based on income elasticity.
Firms producing income elastic goods can plan for capacity changes based on income forecasts.
Car manufacturers cut output during the 2008 recession.
Producers of inferior goods may increase capacity in anticipation of a recession.

Indirect taxes: Value-added tax (VAT) and excise duty.
Excise duty: Government tax on specific goods like cigarettes, alcohol, and petrol.
Valued-added tax (VAT): Tax on some goods and services

Governments impose indirect taxes (VAT and excise duty) to raise revenue.
Governments target products with inelastic demand to avoid consumers avoiding heavily taxed products
Popular targets are cigarettes, alcohol, and petrol because demand is price inelastic.

Governments consider PED when granting subsidies to producers.
Subsidies shift the supply curve to the right (increase supply).
Subsidies need to be price inelastic if designed to help the poor by making goods cheaper.
Subsidies are often given to farmers because demand for many food products is inelastic, helping to keep food prices lower.