Unit 7 Income elasticity of demand(2)

ECO 1003 - Microeconomics

Lecture 7: Income Elasticity of Demand

Learning Objectives

  • Define Income Elasticity of Demand (IED)

  • Measure IED using the mid-point method

  • Understand the importance of IED

Impact of Income Changes on Demand

  • Increase Income: Identify how consumption changes for various goods

    • Diamond: Buy more

    • Inferior Goods: Buy less

    • Others: No change in demand

What is Income Elasticity of Demand (IED)?

  • Measures the responsiveness of quantity demanded to changes in consumer income.

  • Key questions that IED addresses:

    • Why do consumers dine out more with increased income?

    • Why do consumers opt for luxury goods when income rises?

    • Why is the quantity demanded for basic goods like salt unchanged despite income increases?

    • Why do firms change prices during different economic conditions?

Calculating Income Elasticity of Demand (IED)

  • Formula for IED:

    • ( IED = \frac{% \Delta QD}{% \Delta Income} )

  • Percentage change calculation:

    • ( \text{Percentage Change} = \frac{(New Value - Old Value)}{Old Value} \times 100 )

  • IED can be positive or negative based on goods (normal vs. inferior).

Example Calculation of IED

  • Scenario: 10% increase in income leads to a 5% increase in attendance to private universities.

  • Calculate IED:

    • ( IED = \frac{5%}{10%} = +0.5 )

  • Interpretation:

    • Positive sign indicates higher income increases attendance.

    • A 1% income increase leads to a 0.5% increase in demand.

Interpretation of IED Values

  • Decreasing Demand:

    • 1% increase in income results in decreased quantity demanded (e.g., bus tickets).

  • Inelastic Demand:

    • 1% increase in income results in less than 1% increase in quantity demanded (e.g., food staples like milk, rice).

  • Elastic Demand:

    • 1% increase in income results in more than 1% increase in high-demand goods (e.g., luxury items, travel).

  • Classification:

    • Normal Goods (+): Demand increases with income (IED > 0).

    • Inferior Goods (-): Demand decreases with income (IED < 0).

Activities to Analyze IED

  • Interpret IED for given products and determine if each is a normal or inferior good.

Application of IED

  • Case Study: Anca’s income increase from AED 400,000 to AED 500,000 results in spending on branded clothes rising from AED 15,000 to AED 25,000.

  • Calculation:

    • ( IED = \frac{\left(\frac{25,000-15,000}{15,000}\right)}{\left(\frac{500,000-400,000}{400,000}\right)} = \frac{\frac{10,000}{15,000}}{\frac{100,000}{400,000}} = +2.67 )

  • Interpretation:

    • Demand for branded clothes is income elastic, indicating it's a normal good.

Concept Check: Understanding EID Importance

  • Review IED values for various goods and classify them as inferior, necessity, or luxury:

    • High-fat meat (IED = -1.6): 1% increase in income causes 1.6% decrease in demand (Inferior Good).

    • Apple iPhones (IED = +4.3): Luxury Good, significant increase in demand with income.

    • Going to cinema (IED = +1.33): Normal Good, demand increases with income.

    • Bread (IED = -0.42): Necessity Good, demand declines slightly with income.

    • Shoes (IED = 1.10): Normal Good, demand rises with income.

Importance of Income Elasticity of Demand

  • Helps understand how quantity demanded responds to income changes.

  • Essential for businesses to predict demand changes based on market conditions.

  • Distinguishes between normal goods (demand rises with income) and inferior goods (demand falls with income).

  • Informs pricing strategies and market targeting:

    • High elasticity: Premium pricing for affluent consumers.

    • Low elasticity: Competitive pricing for the general market.

  • Utilized in public policy making for revenue forecasting and demand stimulation during recessions.

  • Important for investors evaluating growth potential in industries linked to income elasticity.

Case Study: Salik Toll Gate System in Dubai

  • Description: Role of Salik in traffic management and revenue generation.

  • Hypothetical Data:

    • Period 1: Average income = AED 20,000; Toll crossings = 50,000.

    • Period 2: Average income = AED 22,000; Toll crossings = 55,000.

  • IED Calculation:

    • Use formula to assess Salik's demand elasticity.

  • Interpretation: Determine the nature of Salik as necessary, inferior, or luxury good and explore its substitutability.

  • Discuss implications of IED findings for Salik in relation to previous importance points.