Monday, 4 April 2011

Income Elasticity of Demand (Microeconomics)

The theory of income elasticity of demand measures the responsiveness of demand to a change in income levels. It is assumed that all other factors affecting demand are unchanged, the only thing that may change it is income.

The formula for income elasticity of demand (YED) is:

YED = % Change in quantity demanded ÷ % Change in income.

The result of the formula will tell us one key thing, and the positive or negative sign is vital as it tells us whether the change in income has caused an increase or a decrease in demand levels. Goods with a positive income elasticity of demand are known as normal goods. Meaning a rise in comes causes demand for these goods to rise as well. Examples of these normal goods are holidays, eating at restaurants, flat-screen TVs and home improvements. As with PED, if the figure given by the formula is between 0 and 1 then the good is seen as income inelastic, if the result is greater than 1 then the good is seen as income elastic.

Goods that have a relatively large income elasticity of demand are sometimes referred to as 'superior goods'. These are normal goods in theory, but as demand for them rises considerably after an income rise then they are seen as more superior. It's difficult to offer examples as what may be a normal good for a well off family may be a seen as a superior good by a poorer family.

However, if the result of the figures entered into the formula is negative then the good in question is known as an inferior good. This means that a rise in income levels will cause a fall in demand for these goods, and vice versa. Examples of these inferior goods would be supermarket own brand food and second-hand items.

Lets try an example. Say incomes rose by 5%, creating a rise in demand of 10% for Ford cars. (These figures are made up)

YED = 10% ÷ 5% = 2. So therefore these Ford cars are a normal good which are income elastic, meaning a rise in incomes has a more than proportionate rise on demand.

Just remember when using the formula that if demand or incomes fall then a minus sign needs to go before the percentage. That's all for income elasticity of demand, cheers.

No comments:

Post a Comment