Chap10

• Income elasticity of demand (YED)

  Shows how responsive the demand for a product is to a change in income
• Income elasticity


  • -1 < YED < 1 -> income inelastic
  • YED > 1 or YED < -1 -> income elastic
• Types of goods based on income elasticity

  • Normal goods (Positive income elasticity)
  • Inferior goods (Negative income elasticity)
• Normal goods


  If, following an increase in income, more of the good is demanded
• Necessities


  0 < YED < 1 (income inelastic), basic goods like milk, food, electricity, petrol, water
• Luxury goods


  YED > 1 (income elastic), discretionary spending on cars, branded clothes, holidays
• Inferior goods


  If, following an increase in income, less of the good is consumed
• When real incomes are rising during a period of economic growth


  Demand for inferior goods will fall causing an inward shift of the demand curve
• When real incomes are falling during a period of recession


  Demand for inferior goods will rise
• Luxury goods


  • Luxury chocolates
  • Exclusive resorts
  • Business class travel
  • Fine wines and dining
• Inferior goods


  • Own label discounters
  • Urban bus transport
  • Cigarettes
  • Economy class travel
• Price elasticity of demand (PED)


  Tells businesses what their pricing strategy should be in order to increase total revenue or how demand for their own product will change following a price change by their competitors (substitutes)
• If PED is inelastic, then a rise in price increases total revenue and a fall in price reduces total revenue
• If PED is elastic, then a rise in price reduces total revenue and a fall in price increases total revenue
• Knowledge of YED is relevant for a firm


  It can estimate how demand for its products will change following a change in incomes
• If income elastic


  A predicted rise in incomes may encourage firms to increase their output, plan ahead to increase their capacity or a predicted recession will result to a cut in output
• If inferior good


  A predicted recession could mean to increase output
• Understanding the burden of taxation on producers and consumers

  The more price inelastic the good the higher the burden of tax for consumers
• Revenue for governments derives mainly from taxes which means if they want to increase revenue they should target inelastic goods
• Governments usually avoid taxing goods essential to human survival or with few substitutes such as food, water. Popular targets will usually be cigarettes, alcohol, petrol
• Subsidies


  Increase supply -> decrease market price
• If subsidy is designed to help poor people then the target should be on price inelastic goods which will create a bigger fall in price
• If demand is price elastic then the increase in supply will reduce price slightly
• Subsidies usually are given to farmers, where PED is inelastic so as to keep fruit prices lower