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Income Elasticity of Demand - Coggle Diagram
Income Elasticity of Demand
Definitions
YED
YED refers to the degree of responsiveness of quantity demanded of a good to a change in income of consumers
Income elastic demand
It happens when YED is more than 1, and it means that when there is a change in income of consumers, the quantity demanded of the good changes by more than proportionately, ceteris paribus.
Income inelastic demand
It is when YED is between 0 and 1, and means that a change in the income of consumers leads to a less than proportionate change in quantity demanded of the good.
Signs of YED
Positive
if the sign of YED is positive, then when the income of consumers rise, then the quantity demanded of the good rises (Normal good)
Negative
if the sign of YED is negative it means that a rise in income leads to a fall in quantity demanded of the good (Inferior good)
Graphical representation of YED
Using an Engel curve, which is a line showing the quantity demanded of the good at different levels of income.
Income elastic demand is represented by an Engel curve touching the income axis, while income inelastic demand is represented by an Engel curve touching the quantity axis
if the Engel curve is downward sloping, then the good has a negative income elasticity of demand, meaning it is an inferior good
Applications and limitations of YED
Applications
For producers
with the knowledge of YED, producers can plan and adjust their productions to maximise their profits and minimise their losses
when the income of consumers rise, a substantial rise in the quantity demanded of goods with high positive YED will be expected, thus profit maximising producers should increase their production of the good in anticipation of the rise in quantity demand. while goods with negative YED will experience a fall in demand with rising income, thus producers of such goods should cut down on their production to avoid accumulation of stocks and losses. Such producers can also consider venturing into markets for goods with high income elasticity of demands if they expect the rise in national income to be sustained for a long period of time.
For government
with the knowledge of YED, governments can plan their expenditure on social goods and services to provide more and better services to meet the increasing demands of the public
When incomes rise, people will expect to have better recreational amenities, medical care and educational facilities as these are goods with high positive YEDs. thus, the knowledge of YED allows the government to understand and identify areas to increase spendings.
Limitations
ceteris paribus agreement
the concept of PED and YED operates on the Ceteris paribus assumption, however, in the real world more than 1 factor of demand can change simultaneously, when that happens it becomes difficult to pin point the exact cause of the change in demand. therefore, making it difficult to implement pricing and output strategies
Accuracy of data
The data collected may not be accurate due to changes in other factors of demand. this is because of the time lag between data collection and implementation of appropriate strategies, the small sample size that may be insufficient to reflect the real elasticity value and the difficulty in data collection can lead to differences in the YED value, thus, making it inaccurate.
Factors affecting YED
degree of necessity of the good
the smaller the degree of necessity of the good, the more income elastic its demand. this is because the demand of services and luxury items expand rapidly with increasing income, while the demand for basic goods only increase by a little