Income Elasticity of Demand

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Income Elasticity of Demand

In the questions you tried above, notice that the value for the income elasticity of demand can be positive or negative, a bit like the cross price elasticity of demand.

Most goods are normal goods. A normal good is one where, as one would expect, its demand rises as consumers' income rises. There is a positive relationship between real income and the demand for the good in question. Of course, this also means that the demand for these types of goods falls when real incomes fall, as the third question above demonstrated.

Some goods are known as inferior goods. With inferior goods, there is an inverse relationship between real income and the demand for the good in question. If real incomes rise, the demand for an inferior good will fall. If real incomes fall (in a recession, for instance), the demand for an inferior good will rise. Here are a couple of classic examples of inferior goods:

Black and white TVs. This one is a bit old fashioned. The idea is that as people get richer, they are more likely to buy a new colour TV than an inferior black and white TV. A slightly more up-to-date example might be audiotapes, as more people buy CD players.

Bus travel. Notice that the second question above referred to this example. As people get richer, they are more likely to buy themselves a car, or use a taxi, rather than rely on the more inferior bus, so the demand for bus travel falls as real incomes rise.

The values of income elasticity of demand for normal and inferior goods

Given the analysis above, you have probably worked out that normal goods are ones with a positive income elasticity of demand, whereas inferior goods have a negative income elasticity of demand.

Some text books sub-divide normal goods into necessities and luxury goods.

Necessities are defined as goods that are normal (so EY > 0), but the demand for these goods does not rise that much as a result of an increase in real incomes. If one's real income doubles overnight, would one really buy twice as much bread? Probably not. Perhaps four loaves a week instead of three so that one can throw out half a loaf mid-week and start a fresh one. Bread is a necessity, not a luxury. For a given percentage rise in real incomes, the demand for these goods tends to rise, but by a smaller percentage. So the value for the income elasticity of demand is between zero and one.

Luxuries, therefore, are goods whose income elasticity of demand is greater than one. If real incomes in the UK rise quite significantly, the demand for things like fast cars, expensive holidays abroad and dishwashers tend to rise at an even faster rate. Many people who did not purchase these goods and services at all will now have enough money to get involved.

Luxuries

The table below summarises the above:

Normal or inferior good? Necessity or luxury? Examples Value of the income elasticity of demand
Normal Necessity Basic foodstuffs, including bread, tea, fruit and green vegetables. 0 < EY < 1
Luxury Foreign holidays, fast cars, meals out and fine wines. EY > 1
Inferior   Bus travel and audio tapes EY < 0

Before we move on to explain what a 'giffen' good is, it is important that you understand how the income effect and the substitution effect of a price change affect the quantity demanded of different types of goods.

The substitution effect of a price change

This is the easy one. For all goods, a rise in price relative to other goods will cause consumers to demand less of the good in question and more of the other goods. If the price of a good fell, ceteris paribus, then consumers would buy more of that good at the expense of other goods that are now relatively dear. Consumers substitute purchases of the relatively more expensive good for the relatively cheaper good following the price change.

The income effect of a price change

This one is a bit harder. When the price of a good rises, ceteris paribus, then a consumer's real income will fall.

Imagine that you earned £100 a week, after tax, and you spent this money on only two types of good: you buy 6 CDs at £10 a CD and visit a club four times at £10 a go. Now assume that the price of CDs rose to £15. Next week, if you still want to go clubbing four times, you will only be able to buy 4 CDs. The amount that you can really buy has fallen given your fixed nominal income of £100. Your real income has fallen.

The effect on the demand for various goods following a price rise as a result of the income effect will depend on whether the good in question is normal or inferior. Following the price rise, real incomes fall, so for a normal good the income effect will cause the demand for the good to fall (because of the positive income elasticity). For an inferior good, the fall in real income will lead to a rise in the demand for the good as a result of the income effect (because of the negative income elasticity).

Combining the income and substitution effects

The table below summarises what we have said so far. The effects below assume that there has been a rise in the price of the good in question.

Type of good The effect on quantity demanded due to the Substitution effect The effect on quantity demanded due to the Income effect The Total effect on quantity demanded
Normal good Fall Fall Fall
Inferior good Fall Rise Fall (because the substitution effect is thought to be stronger than the income effect)

In other words, If the price of a normal good rises then its demand will fall, as one would expect, resulting in a downward sloping demand curve. If the price of an inferior good rises then its demand will fall, but perhaps not as much as with a normal good. But still, its demand curve will be downward sloping, as expected. The above analysis would be equal and opposite if we considered a price fall.

The Giffen good is an unusual type of inferior good. Basically, it is a very inferior good! I think the best example is potatoes during the potato famine in Ireland.

During the potato famine of the nineteenth century, appalling harvests meant that the price of potatoes rose (you might want to draw a supply and demand curve to explain this!). If it was a normal, or even an inferior good, one would have expected the demand for potatoes to fall as a result of this price rise. What actually happened was that the demand for potatoes rose?!?

Why did this happen? The key point to understand is that potatoes formed a huge part of a poor Irishman's diet in those desperate days. People spent most of their income on potatoes, leaving a small proportion of their income to purchase, say, meat; a source of protein and a relative luxury. When the price of potatoes rose sharply, the income effect of this price change was immense. Real incomes fell dramatically. The reaction of the Irish was sensible, in a way. They decided to stop buying the relative luxury, meat, all together, as their real incomes had fallen so much, and spend all of their income on the one good without which they could not survive: potatoes. So the result of the large rise in the price of potatoes was an increase in demand for potatoes! The income effect was much stronger than the substitution effect and, unusually, the demand curve for potatoes was upward sloping!

The table below summarises the situation following the large rise in the price of the giffen good:

Type of good The effect on quantity demanded due to the Substitution effect The effect on quantity demanded due to the Income effect The Total effect on quantity demanded
Giffen good Fall Rise Rise (because the income effect was much stronger than the substitution effect)

There are a few other examples of goods that have (unusually) upward sloping demand curves. Very expensive goods with a 'keeping up with the Jones' factor, for instance. If the price of a Rolls Royce rises, their demand can, perversely, rise, as more people want to be 'seen' in the new, more expensive model! It has 'snob' appeal. The best example is probably the stock market boom leading up to the crash in October 1987. Speculation of never ending price rises caused demand to keep rising. A price rise was seen as a 'good thing' causing further increases in demand, even if the economic fundamentals of the company whose stock was popular were unchanged. Remember, though, that example of goods with upward sloping demand curves are few and far between. The downward sloping curve is true of nearly all goods and services.

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