Income elasticity of demand (YED)

Key terms:

Income elasticity of demand (YED) - the responsiveness of demand for a good or

service following a change in real income levels.

YED formulae - % change in demand for a good or service / % change in consumer

income.

Normal good - a good or service with a direct relationship between income and
demand, i.e a good where demand for the product rises as income rises.

Inferior good - a good or service with an inverse relationship between income and
demand, i.e a good where demand falls as income rises.

Engels law - the theory which states that as a households income rises the percentage
spent on some purchases e.g. food decreases, while the proportion spent on other goods
(such as luxury goods) increases.

YED range of values

Goods and services with a YED value > 1 are elastic (i.e a top heavy fraction) as the %
change in demand is greater than the initial % change in income.

Goods and services with a YED value > 0 but < 1 are inelastic (i.e a bottom heavy
fraction) as the % change in demand is smaller than the initial % change in income.

Goods and services with a YED value = 1 have unitary elasticity as the % change in
demand is equal to the initial % change in income.

Goods and services with a YED value < 0 have negative elasticity and are deemed
inferior goods and services. Unlike normal goods the relationship between quantity
demanded and consumer income is inverse.

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InThinking www.thinkib.net/Economics 1
Activities

1. Write down again a list of your 10 main expenditures (in a month) and again next to each
item write down whether you consider the good or service to be a basic necessity or a luxury
item? Now imagine that your income rises by 50%. Next to each assign one of the following
labels to each item:

a. Following my rise in income of 50%, I would increase my consumption of the product by

more than 50%.

b. Following my rise in income of 50%, I would increase my consumption of the product by

less than 50%.

c. Following my rise in income of 50%, I would increase my consumption of the product by

about 50%.

Reflection: what has the above taught you about YED?

Activity 2: Video activity

Watch the video on YED and then complete the activities that follow:

(a) A worker is awarded a 10% pay rise

(after taxes have been deducted). In
response the consumer cancels their cheap £
30 a month membership at a sports club and
upgraded to the premium membership, which
costs £ 40. Calculate the YED for
premiership sports club package?

(b) Describe the YED of this good.

(c) Complete the diagram to the right, by

adding the appropriate labels.

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(d) Complete the missing summary by filling in the missing words:

As a general rule basic necessity items are income or YED________, meaning that the
resulting % change in quantity demanded is ________ than the initial change in real
income. By contrast luxury goods are normally YED ________. This means that the
resulting % change in quantity demanded is _________ than the initial change in real income.
Other products may be unitary or unit elasticity. This means that the resulting % change in
quantity demanded is ______ to the initial change in real income. These goods are neither
luxury goods or basic necessities and examples might include second hand cars or medium
luxury products.

Activity 3: Applying YED theory

1. The following table documents the relationship between sales of new cars in the USA and
income levels:

a. Complete the missing blanks at the bottom of the table (numbers in brackets indicate
negative values).

Growth in new car sales

Year Real GDP growth (%)
(%)
August 2006 2.39 1.49
August 2007 1.87 (8.72)
August 2008 (2.77) (8.11)
August 2009 (0.24) 0.8
August 2010 2.73 (21)
August 2011 1.68 7
August 2012 1.28 20.56
August 2013 2.66 16.28
August 2014 2.49 16.67
Average for the period

b. Based on the above figures calculate the level of YED for the new car sales in the USA?

c. Describe the relationship between income levels and new car ownership in the USA?

d. Provide two reasons why the sale of new cars is income elastic.

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Activity 4: Inferior goods

Watch the following short video and then answer the practise questions attached to your
handout.

1. The diagram to the right illustrates an

inferior good. This is one that has an inverse
relationship between income and demand. As
a person's income rises demand for this type
of good falls.

(a) Provide some examples of inferior goods

or services.

(b) Inferior goods will have a YED lower than

_________

(c) Why might public transport be an example

of an inferior good?

Activity 5

Which of the following goods and services do you think are examples of inferior goods
in the USA?

• Ramen noodles
• Bread / bread products
• Cheap microwave pizzas
• Oil
• Public transport
• Used cars
• Potatoes
• Unhealthy foods including junk foods
• Supermarket own brand items
• Samsung smart phones

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Activity 6: TOK activity on inferior goods and services

a. Is a quality product always more expensive to manufacture or buy than a mediocre

product?

b. Given that all giffen goods are inferior goods, does this mean that inferior goods are also
giffen goods?

Activity 7

Cigarettes have a negative YED in the USA

and Europe. Does this mean that cigarettes and
other tobacco products are actually inferior
goods? What are they inferior to?

Activity 8: Sales rise when economic growth and consumer confidence rises

Watch the following video at: www.youtube.com/embed/g2eiQ2ql_s

And then describe which products saw the largest rise in sales, following rise in incomes and
consumer confidence (YED elastic) and which saw a smaller rise (YED inelastic)

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Activity 9: Engel Curve

Engels theory states when income for a

low-income households rises, demand for
some products e.g rice increases. This is
because it is considered a normal or even
luxury good by households on low
incomes. However, the same good is
considered a necessity good by
households on middle incomes while
wealthy households consider the food
item an inferior good. This means that as
the family’s income rises further their
demand for the staple will fall. The
diagram illustrates an Engel curve.

Complete the following sentence by

filling in the missing blanks.

inelastic
In area A the YED of rice would be _________, elastic
in area B _________ and in area C the YED
negative
would be _______________.

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Activity 10: Calculating YED (HL only)

(a) Sarah receives a pay rise and her income rises from $ 40,000 to $ 50,000. As a result of
this she increases her expenditure on holidays from $ 2,000 per year to $ 2,800. She also
purchased a more expensive gym membership which now costs $ 100 per month rather the
previous $ 80 per month. By contrast her food expenditures rise only from $ 500 per month
to $ 520. She also calculates that her monthly expenditures on heating her house did not
change. Following her wage rise she spends slightly less on public transport, reducing her
monthly expenditure from $ 150 per month to just $ 100.

Calculate her YED for: Text

• Holidays
• Gym membership
• Food
• Heating for her house
• Public transport

(b) Explain why her expenditure on public transport fell following her pay rise?

(c) Brian loses his teaching position where he earned £2,500 a month and was forced to live
of unemployment insurance, where he received just £1,000 a month. As a result he is forced
to cancel his planned skiing holiday and instead stay at home, looking for a new position. He
also decides against purchasing a new car, which would have cost him £10,000 and instead
purchases a cheaper model for just £2,000. He also reduces his weekly food bill at the
supermarket by identifying certain supermarket brand products, which he can purchase rather
than the branded items he purchased previously. In total his food bill fell from £400 a month
to £250. As a final cost cutting measure he quits his gym membership and instead takes up
jogging and decides to turn down the heating at his house, reducing his monthly gas bill from
£120 each month to £90. His spending on rent, internet and electricity remain unchanged.

Calculate his YED for:

i. Car purchases
ii. Food
iii. Gym membership
iv. Heating his home
v. Rent, internet, electricity expenses
vi. Explain why he is unable or unwilling to reduce his monthly expenditure on rent,
internet and electricity?

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Activity 11: Link to the assessment (HL)

Income elasticity of demand can be found in paper one and three of the IB economics
exams. Paper three (HL only) would contain YED calculations, similar in style to the
previous activity, number 10. A typical paper one question might require candidates to
reflect on the uses and implications of YED theory. An example from the HL syllabus,
which can also be provided as a homework exercise, is included below:

Part (a)

Explain using appropriate diagrams why the income elasticity for manufactured goods and
services tends to be higher than the YED for primary products. [10 marks]

Part (b)

“The income elasticity of demand for primary products tends to be lower than that for
manufactured products and services.” Using real world examples, evaluate the implications
of this for producers and for the economy as a whole. [15 marks]

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InThinking www.thinkib.net/Economics 8