Income Elasticity of Demand (AQA A Level Business): Revision Note

The importance of income elasticity of demand

• Income elasticity of demand (YED) measures how responsive the quantity demanded of a product is to a change in consumer income

• When household incomes change, spending on goods and services will either increase or decrease, depending on the type of good or service it is

  • Normal goods can be necessities or luxury goods

    • Necessity good

      • A good where demand rises when income increases

      • E.g. essential clothing, groceries, fuel

    • Luxury good

      • A good where demand increases significantly as income increases

      • E.g. restaurant meals, designer handbags or sports cars

  • Inferior goods - demand for these behaves differently

    • A good where demand falls when income increases

    • E.g. instant noodles or bus travel

Business implications of YED

• Understanding YED helps businesses forecast how demand will change as the economy grows or contracts

  • Businesses are interested in how much the quantity demanded will change for different products

  • This helps them plan their production and products

    • Planning in this way will help them forecast future demand, set production targets and decide when to invest in new capacity or cut costs

• Businesses selling luxury goods must plan carefully for the economic cycle

  • Strong growth in a boom can be followed by sharp falls in a recession

• Businesses selling necessities enjoy more stable, predictable demand

  • They are less exposed to economic downturns

• Businesses selling inferior goods may benefit from rising demand during recessions

  • However, they may need to adapt their strategy when consumer incomes recover, as customers may switch to premium alternatives

Calculating and interpreting YED

• The YED value can be positive or negative and the value is important in determining the type of good

  • A good with a positive YED value is considered to be a normal good

    • Normal goods can be classified as necessities or luxuries

  • A good with a negative YED value is considered to be an inferior good

Formula

$\text{YED = }\frac{\%\mathrm{Change}\mathrm{in}\mathrm{quantity}\mathrm{demanded}}{\%\mathrm{Change}\mathrm{in}\mathrm{income}}$

• The YED value can be positive or negative, and the value is important in determining the type of good

  • A good with a positive YED value is considered to be a normal good

    • Normal goods can be classified as necessities or luxuries

  • A good with a negative YED value is considered to be an inferior good

Interpretation of the numerical values of YED

Influences on YED

• YED is influenced by many factors in an economy that change the wages of workers

  • During a recession, wages usually fall and demand for inferior goods rises while demand for luxury goods falls

  • During a period of economic growth and rising wages, demand for luxury goods increases while demand for inferior goods decreases

  • Other influences on income include minimum wage legislation, taxation and increased international trade