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Income Elasticity of Demand and Types of Goods

Explain how economists use the concept of income elasticity of demand to distinguish between different types of goods.

Category:

Elasticity

[CIE AS level November 2017]

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Answer

Tip: It is important to mention that goods can be classified as necessities. This will help to gain a maximum of marks


Step ➊ : Define income elasticity of demand in the introduction and state it’s formula.


Income elasticity of demand (YED) is defined as a numerical measure of the responsiveness of the quantity demanded following a change in income.

The formula for income elasticity of demand formula is as follows :

YED =

%change in quantity demanded

% change in income

The concept of income elasticity of demand can be used to distinguish between normal goods, inferior goods and luxury goods.


Step ➋ : Explain the different income elasticity of demand values for normal goods, necessity goods,luxury goods and inferior goods.


➤ 2.1 A positive income elasticity of demand is associated with normal goods. An increase in income will lead to a rise in demand for a normal good.

An increase in income leads to an increase in the quantity demanded for a normal good. Conversely a decrease in income leads to a decrease in the quantity demanded for a normal good. Since there is a positive relationship, the YED has also has positive coefficient. Examples of normal goods include food staples, clothing, and household appliances.

➤2.2 The major determinant of income elasticity of demand is the degree of ‘necessity’ of the good.

Necessity goods are products and services that consumers will buy regardless of the changes in their income levels, therefore making these products less sensitive to income change. A necessity good is a type of normal good. Normal necessities have an income elasticity of demand of between 0 and +1. As income rises, the demand for necessity goods rises by only a little : it is said that demand rises less than proportionately to income. Items such as Staple food products such as bread and vegetables are necessity goods. This is because they have a low income elasticity of demand.

➤ 2.3 Luxury or superior goods have an income elasticity of demand greater than 1, which means they are income elastic.

This implies that consumer demand is more responsive to a change in income. The demand for luxury goods expands rapidly as people’s incomes rise. Thus items such as cars and foreign holidays have a high income elasticity of demand. Other examples of luxury goods include fine wines spirits, high quality chocolates and sports cars

➤ 2.4 Inferior goods have a negative income elasticity of demand.

An increase in income will cause a decrease in the quantity demanded for an inferior good. Conversely, a decrease in income would cause an increase in the quantity demanded for an inferior good. Here, the YED has a negative coefficient. The demand for inferior goods actually decreases as people’s incomes rise beyond a certain level. An example of an inferior good is cheap margarine. As people earn more, they switch to butter or better quality margarine.

➤ 2.5 If Income Elasticity of Demand = 0, this means that the demand for the good isn’t affected by a change in income.


Step ➌ : Conclude (summary)


To conclude, normal goods, inferior goods and luxury goods have different values of income elasticity of demand.


♕ Marking Scheme


For Knowledge and Understanding: For an understanding of what income elasticity measures without a formula or with an inaccurate formula (1 mark)

For an accurate formula (2 marks) 2 marks maximum
For Application (and knowledge and understanding): For stating that a normal/luxury good has a positive coefficient (1 mark) and explaining why this occurs with reference to the change in income and change in quantity demand. (1 mark) (Up to 2 marks)

For stating that an inferior good has a negative coefficient (1 mark) and explaining why this occurs with reference to the change in income and the change in quantity demand. (1 mark) (Up to 2 marks)

For explaining why a necessary good has a low, positive coefficient or why a luxury good has a high positive coefficient with reference to the % change in income and % change in quantity demand. (Up to 2 marks)


♕ Guidance


In order to score well here, candidates need a good understanding of the concept of income elasticity of demand. They then need to apply the concept to distinguish between normal, necessary and inferior goods.

♕ Examiner’s report


Many candidates made a good start to this question by providing an accurate formula for the calculation of income elasticity of demand. Many then went on to provide a good explanation of normal goods and then clearly distinguish these types of goods from inferior goods. Disappointingly, many candidates seemed unaware of how goods could be classified as necessities and they failed to gain marks as a result. Some candidates started badly by providing an incorrect formula and others wasted time by providing information on everything they had learned about elasticity. It was disappointing that many candidates provided material that was not relevant to the question set and they scored poorly as a result.

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