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IBEconomicsDPSLRevision Notes2. Microeconomics2.5 Income Elasticity of Demand (YED)2.5.1 Definition, Calculation & Illustration of YED

Definition, Calculation & Illustration of YED (DP IB Economics)

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DP Economics: SLDP Economics: HL

Definition & Calculation of YED

  • Changes in income result in changes to the demand for goods/services

    • Economists are interested in how much the quantity demanded will change for different products

  • Income elasticity of demand (YED) reveals how responsive the change in quantity demanded is to a change in income

Calculation of YED

  • YED can be calculated using the following formula

text YED =  end text fraction numerator percent sign space change space in space quantity space demanded over denominator percent sign space change space in space income end fraction space equals space fraction numerator percent sign triangle space in thin space QD over denominator percent sign triangle in space straight Y end fraction

Worked Example

A consumer's income rises from SG$ 100 to SG$ 125 a week. They originally consumed 12 bubble teas but this increased to 15 bubble teas a week. Calculate the YED of the bubble teas 

[2 marks]

Answers:

Step 1:  Calculate the % change in QD

  percent sign triangle QD space equals space fraction numerator 15 minus 12 over denominator 12 end fraction space cross times 100 percent sign triangle QD space equals space 25 percent sign 

Step 2: Calculate the % change in Y

percent sign triangle Y space equals space fraction numerator 125 space minus space 100 over denominator 100 end fraction space straight x space 100 percent sign triangle Y space equals space 25 percent sign

Step 3: Insert the above values in the YED formula

Y ED space equals space fraction numerator percent sign triangle space in thin space QD over denominator percent sign triangle in space straight Y end fraction Y ED space equals space 25 over 25 Y ED space equals space space 1

(Two marks for the correct answer or 1 mark for any correct working)

Interpreting 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
       

Engle Curves

  • Engle curves are a model used to illustrate the relationship between income and the quantity demanded (QD)

    • Income is presented on the Y-axis and quantity demanded on the X-axis
        

The Value of YED Determines the type of good and Response to Changes in Income


Value


Type of Good


Explanation


Engel Curve

0→1

Necessity

  • Normal good - quantity demanded increases when income increases

  • Income inelastic which means that it is relatively unresponsive to a change in income

  • E.g. A 10% increase in income leads to a 3% increase in QD

2-5-1---interpreting-yed-values---necessity

YED > 1

Luxury

  • Normal good - quantity demanded increases when income increases

  • Income elastic which means that it is relatively responsive to a change in income

  • E.g. A 3% increase in income leads to a 10% increase in QD

2-5-1---interpreting-yed-values---luxury

YED < 0

Inferior Good

  • Quantity demanded decreases when income increases

  • E.g. Consumers switch from purchasing a supermarkets own brand cereal to Kellogg's cereal as income increases

2-5-1---interpreting-yed-values---inferior-good

Examiner Tips and Tricks

Remember this distinction! With PED values the negative sign is always ignored. However for YED, the sign is integral to understanding if the good is a  normal (+) or inferior (-) good.

Factors that Influence YED

  • YED is influenced by any factors in an economy which change the wages of workers

    • During a recession wages usually fall and 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, increased international trade

The Importance of YED

  • YED is crucial for firms as it helps them understand consumer behaviour, analyse markets, plan strategies, make informed investment decisions, and adapt to changes in the sectoral structure of the economy

  • By assessing the income elasticity of demand, firms can effectively navigate evolving market dynamics and position themselves for sustainable growth
     

An Explanation of how Firms can use YED Effectively

Factor

Explanation

Understand consumer behaviour

  • YED helps firms understand how changes in income levels affect consumer demand for their products or services
     

  • By examining the income elasticity of demand for different goods and services, firms can identify which sectors are more sensitive to changes in income

Adapt to changes in the sectoral structure of the economy

  • Changes in the income elasticity of demand can indicate shifts in consumer preferences and patterns of consumption

    • Firms need to adapt to these changes to remain competitive
       

  • If a sector experiences declining demand due to a low income elasticity (YED < 1), firms may need to consider diversifying their product offerings or exploring new markets to sustain growth
     

  • Sectors with high income elasticity (YED > 1) can provide opportunities for firms to specialise and cater to the growing demand
     

Example

  • As income levels increase, consumers' preferences and concerns about environmental sustainability may lead to a higher demand for electric vehicle's (EVs)
     

  • The income elasticity of demand for EVs can help firms estimate the potential market growth and justify investment decisions
     

  • With a YED > 1, the EV sector is likely to experience rapid expansion as income levels rise, prompting firms to invest in manufacturing facilities, research and development, and charging infrastructure
     

  • This will further shift the sectoral structure of the economy, as the rising demand for EVs can result in the growth of related industries such as battery manufacturing, renewable energy, and charging networks

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