Applications and Measurements of Income Elasticity of Demand

Income elasticity of demand helps us to measure the health of an industry, future consumption patterns and economic reasoning behind investment decisions. The concept helps the managers to see the opportunities to maximize their profits.

When to increase or decrease your production?

The income elasticity of demand provides an answer to this question. We can find out the impact of increase or decrease in income of our targeted consumers on demand of our products. If we can catch up with economic cycles of a country and change in average income of the people, we can plan and make business decisions well in time to stay ahead of our competitors.

If we are selling necessities, the impact of an increase in income shall be slower or zero. However, in case of luxury products the rise in the income calls for an increase in our products to meet the rising demand.

The public managers can benefit from the concept of formulating public policies. In a study, Atakhanova and Howie (2007) calculated that income-elasticity of demand for electricity in the residential sector is very low in comparison to demand in industrial and service sectors in Kazakhstan. They also discovered that overall income related elasticity of demand for electricity is also very low. They concluded that there would be no socio-political problem on electricity production if no further investment is made in the business. The public managers prefer to policies which bring investment in those products or services where income elasticity is higher.

Measurement

You can find out income-elasticity of demand by dividing percent change in demand of the quantity with percent change in income. You can use different formulas.

Suppose we have this data:

Q1    =      Initial quantity

Q2    =      Changed quantity

Y1     =      Initial Income

Y2     =      Changed income

You can measure percentage change in Quantity by these calculations:

=      {(Q1-Q2)/[1/2(Q1+Q2)]} x 100

You can measure percentage change in income as under:

=      {(Y1-Y2)/[1/2(Y1+Y2)]} x 100

By combining these two we find this simple formula:

Here "Ey" is an expression of income elasticity of demand.

Another simple formula to calculate elasticity of demand is:

Practical Prepositions

Suppose we are in the housing business. Due to overall economic deterioration, the income of our targeted consumers falls by 6% annually. It leads them to purchase 5 million fewer houses and demand falls from 25 to 20 million. What would be income elasticity of demand?

We already have 6% drop in income. To calculate the percent change in quantity we use this formula:

=      {(Q1-Q2)/[1/2(Q1+Q2)]} x 100

=      {(25-20)/[1/2(25+20)]} x 100

=      (5/22.5)x100

=      22%

Ey= 22/6 = 3.66

2-     Suppose you are selling 1000 items of a product having an elasticity of demand 1.2. You see an increase of 20% in the annual income of the people of that particular income group. How much production of that product shall maximize your profits by coming up to the increased demand.

How much would be the change in the demanded quantity of the product?

First, we shall find out the percent change in quantity by multiplying elasticity with percent increase in income.

=      1.2x20 =24%

There will be 24% increase in demand for the product which means we will need to produce 240 more items to meet this demand and to maximize our profits.

3-     Suppose income of every Pakistani increases by 200%. Everyone will have more money so demand for many inferior products shall fall. Suppose demand for low quality wine drops by 10%. We can calculate it in a straightforward way as:

10%/200%=       -0.05

It is an example of negative elasticity of demand.

Some Real World Income Elasticities

In United States following products have different income elasticity of demand:

 Product Income Elasticity Elasticity Level Oversea Travels 3.08 Elastic Motion Pictures 3.41 Elastic Housing Services 2.45 Elastic Electricity 1.94 Elastic Restaurant Food 1.61 Elastic Mass Transport 1.38 Elastic Petrol and Gasoline 1.36 Elastic Hair Cuttings 1.36 Elastic Cars 1.07 Elastic Dentist’ Services 1.00 Unitary Elastic Shoes and other footwear 0.94 inelastic Tobacco 0.86 inelastic Alcohol 0.62 inelastic Furniture 0.53 inelastic Clothing 0.51 inelastic Newspapers 0.38 inelastic Phone 0.32 inelastic Food 0.14 inelastic

Sources: H.S. Houthakker and Lester D. Taylor, “Consumer Demand in the United States,” and Henri Theil, Chines-Fan Chung and James L. Scaler, Jr., “Advances in Econometrics”

In this table, inelastic does not mean entirely inelastic which equals to zero. It is above zero but relatively inelastic. According to statistician Ernst Engel (1821-1896) demand for low necessities like food also changes but at snail's pace.

Elasticity Definition

Price Elasticity of Demand

Measurement of Demand Elasticity

Supply Curve and Elasticities

Perfect Price Elasticity of Supply

Exceptions to Demand and Supply

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