Unit 7 Elasticity of Income

ECO 1003- Microeconomics
LECTURE 9
Income elasticity (of demand)
Outline
• Define Income elasticity of demand
• Measure the income elasticity of demand using the
mid-point method
• Show the importance and significance of income
elasticity of demand
Law of Demand
• Law of demand is a Price per cup of Espresso coffee
fundamental principle of AED 80
economics. It says AED 70 70
• The higher the price of a good, AED 60 60
the less consumers will
purchase AED 50 50
• A negative relationship between AED 40 40
the price of a good and its
AED 30 30 D
quantity demanded
AED 20 20
• But, What is the expected
reaction of consumers when AED 10 Series1; 10
their incomes go up? AED 0
40 50 60 70 80 90 100 110 120 130
• Will they Buy more of a good A? QD
• Will they Buy less of a good A?
• Will they not change
consumption?
What is Income Elasticity of Demand (IED)?
• Income Elasticity of Demand (IED) is “the degree of
responsiveness in quantity demanded to a change in
income”
• Elasticity of demand answers very important questions:
• By how much do people change the quantity they demand in
response to a change in income?
• Why do consumers dine out more when their income increases?
• Why do consumers buy luxurious goods when their income
increases?
• Why do consumers buy the same quantity of sales even if their
income increases?
• Why do companies increase prices during expansion and reduce
them during recession?
Income Elasticity of Demand (IED)
• IED is measured by the ratio of the percentage change in the
quantity demanded to the percentage change in the income.
• The IED is calculated as:
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 % ∆ 𝑄 𝐷

𝐼𝐸𝐷= =
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒 %∆ 𝐼
• Note that the IED can be positive or negative
• A percentage change is expressed:
( 𝑵𝒆𝒘 𝒗𝒂𝒍𝒖𝒆− 𝑶𝒍𝒅 𝒗𝒂𝒍𝒖𝒆)

𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝒄𝒉𝒂𝒏𝒈𝒆= 𝑥 100
(𝒏𝒆𝒘 𝒗𝒂𝒍𝒖𝒆 + 𝑶𝒍𝒅 𝒗𝒂𝒍𝒖𝒆)/ 𝟐
Concept check
• A survey says that a 10% increase in income causes the
number of students who choose to attend private
universities to go up by 5%.
• Calculate the IED for private universities.
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝑖𝑛𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 % ∆ 𝑄 𝐷 5 %
𝐼𝐸𝐷= = = =+0.5
𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝑖𝑛 𝐼𝑛𝑐𝑜𝑚𝑒 %∆ 𝐼 10%
• Interpret the value of the income elasticity of demand
• The “+” sign indicates that the relationship between the change in
income and change in quantity demanded is positive:
• the higher the income, the more people attend private universities.
• The value of 0.5 indicates that a 1% increase in income causes a
0.5% increase in the number of students attending private
education
• Not that the change in QD is less than the change in income.
Interpretation of Income elasticity of demand
0
Inferior goods (-) (IED < 0) Normal goods (+) (IED > 0)
Necessity goods Luxury goods

0 1
• As income rises, QD • As income rises, QD • As income rises,
decreases rise QD rise
• A 1% increase in Income • A 1% increase in • A 1% increase in
will lead to a decrease in Income will lead to Income will lead to
QD a less than 1% a more than 1%
• (Brussels sprout, long- increase in QD increase in QD
distance bus ticket) • (milk, rice, bread) • (Cars, dining out,
organic food,
travel)
IED using the mid-point formula
• The mid-point formula:
𝐈𝐄𝐃 =
% ∆ 𝑄𝐷
=
[( 𝑄2 − 𝑄1
𝑄1 + 𝑄 2 )]
[( )]
% ∆ 𝐼 𝐼2 − 𝐼 1
𝐼1 + 𝐼 2
Assume that Anca’s salary increased from AED

400,000 to AED 500,000 per year. As a result, her
spending on holidays increased from AED 30,000 to
AED 70,000. Her spending on clothes increased from
AED 15,000 to AED 25,000.
Calculate the 𝑄income elasticity of demand for
holidays
𝐈𝐄𝐃 =
% ∆𝑄
=
(
𝐷
[
𝑄 +𝑄 )
−𝑄
=
[ (2
1
1
2 ]
25,000 +15,000 ) ]
25,000 − 15,000
=
[ ( 40 ) ]
10
=
0.25
=+2.25
[( )] [ ( )] [( )]
%∆𝐼 𝐼2 − 𝐼 1 5 00,000 − 4 00,000 1 00 0.11
𝐼1 + 𝐼 2 4 00,000 + 5 00,000 9 00
Practice
• Assume that Anca’s salary increased from AED
450,000 to AED 560,000 per year. As a result, her
spending on Gym membership did not change, but her
spending on clothes increased from AED 20,000 to
AED 28,000.
• Calculate the income elasticity of demand for the
gym membership
• Calculate the income elasticity of demand for clothes
Concept check: show the importance of EID
• The income elasticities of demand for a few goods are tabulated.
Interpret them and decide what type of goods they are (inferior,
necessity, luxury)
Good Value of IED Interpretation Inferior or necessity or
Luxury
High–fat meat -1.6 1% increase in income causes 1.6% decrease in demand Inferior
Apple Iphones +4.3 1%increase in income leads to 4.3% increase in demand Normal
Going to cinema +1.33 1%increase in income leads to 1.33% increase in demand Normal
Chicken +0.42 1%increase in income leads 0.4% increase in demand Normal
Bread -0.42 1% increase in income causes 0.42%decrease in demand Inferior
Shoes 1.10 1% increase in income leads 1.10% increase in demand Normal
Flour -0.36 1% increase in income causes0.36%decrease in demand Normal
Importance of income elasticity of demand
• When the economy is not doing well (recession),
incomes fall, and income elasticity of demand helps
predict which products demand will decline more
rapidly.
• Goods with higher IED are generally hit hardest by
recession
• Cars (+3.0), housing (+1.5), and restaurant meals (+1.4),
concert ticket, holidays,
• Goods with low or negative IED are much less
affected by recession.
• Food prepared at home (+0.2), toothpaste
Concept check
• Which of the following items is likely to have the
highest income elasticity of demand?
A. a bus ride
B. a meal at Taco Bell
C. a vacation home in the Swiss Alps
D. a tank of gasoline
Calculation using the mid-point formula
• Last year, Sefton purchased 60 pounds of potatoes to feed his
family of five when his household income was $30,000. This
year, his household income fell to $20,000 and Sefton
purchased 80 pounds of potatoes.
• Calculate the income elasticity of demand for potato using the
midpoint formula
• All else constant, Sefton's income elasticity of demand for
potatoes is __________
A. negative, so Sefton considers potatoes to be an inferior good
B. positive, so Sefton considers potatoes to be an inferior good
C. positive, so Sefton considers potatoes to be a normal good and a
necessity
D. negative, so Sefton considers potatoes to be a normal good

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ECO 1003- Microeconomics

𝑷𝒆𝒓𝒄𝒆𝒏𝒕𝒂𝒈𝒆 𝑪𝒉𝒂𝒏𝒈𝒆 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑 % ∆ 𝑄 𝐷

• Note that the IED can be positive or negative

• A percentage change is expressed:

( 𝑵𝒆𝒘 𝒗𝒂𝒍𝒖𝒆− 𝑶𝒍𝒅 𝒗𝒂𝒍𝒖𝒆)

Necessity goods Luxury goods

Assume that Anca’s salary increased from AED

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