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

Definition and calculation of income elasticity of demand

• Changes in income result in changes to the demand for products

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

• The income elasticity of demand (YED) reveals how responsive the change in QD is to a change in income

Calculation

• YED can be calculated using the following formula:

Interpretation of numerical YED values

• 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

The factors influencing YED

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

  • During a recession, wages sometimes fall and, more likely, do not rise significantly

    • 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

• YED is also influenced by the nature of the good, as discussed above

  • Luxury or necessity (both are classified as normal goods)

  • Inferior or normal good

The significance of YED to businesses

• Understanding the YED is useful to businesses, as it can help them plan their production and products

  • Planning in this way will help them generate higher profits and have less exposure to downturns in the economy

Production planning 

• A business needs to plan how much it is going to produce, which will help it determine the number of resources, such as raw materials and labour, it will need

• If a business can determine the YED for its products and can accurately predict changes in income, then it can plan whether to increase or decrease production 

• It can help managers with financial planning

• Production planning is easier when the YED is relatively inelastic, as demand is likely to be more constant

Product planning 

• The economy goes through different stages over time, from recession to recovery and growth, and so incomes will fluctuate 

• This is known as the business cycle 

• During a recession, producers of inferior goods will benefit from higher demand but will lose out when incomes rise and consumers return to normal goods

• Some businesses might have different products in their product portfolio to take account of this. For example:

  • Tesco has its "Finest", "Standard" and "Value" range to appeal to all income segments of the market

  • During the 2008 recession, Waitrose introduced its "Essentials" range of products to appeal to more budget-conscious shoppers

  • VW owns Skoda, Audi and Porsche, and it has different products within its range to appeal to different income groups