What this lesson teaches
I can use price, income and cross elasticities to judge how large those changes will be.
Syllabus 9570, 2.1.2(g). Demand and Supply Analysis and its Applications: These outcomes can be affected by price elasticities of demand and supply, income and cross elasticities of demand
Make a guess
Incomes rise by 10% and demand for rice rises by 2%. Is rice a normal good or an inferior good for these buyers?
- Normal, because demand rose as income rose.
- A luxury, because demand rose with income.
- Inferior, because demand rose by less than income.
Show the answer
Normal, because demand rose as income rose.
YED = 2 / 10 = +0.2. Any positive YED means a normal good. Below 1 makes it a necessity.
YED shows how demand responds to income: positive for normal goods, negative for inferior goods.
Income elasticity of demand (YED) = percentage change in demand / percentage change in income, ceteris paribus.
If YED is positive, the good is a normal good: demand rises when income rises. Between 0 and 1, it is a necessity: demand rises less than proportionally. Above 1, it is a luxury: demand rises more than proportionally, like overseas holidays or restaurant meals.
If YED is negative, the good is inferior: demand falls as income rises, as people switch to things they prefer.
Firms use YED to plan. In a boom, sellers of luxuries grow fastest; in a recession, they are hit hardest.
- YED
- % change in D / % change in income.
- Normal
- YED > 0; luxury if > 1, necessity if 0 to 1.
- Inferior
- YED < 0.
| YED | Type of good | Example |
|---|---|---|
| Negative | Inferior | Cheapest instant noodles, for some households |
| 0 to 1 | Normal: necessity | Rice, basic toiletries |
| More than 1 | Normal: luxury | Overseas holidays, fine dining |
Worked example: Income rises, meal demand falls
Incomes of a group of households rise by 8%. Their demand for a cheap ready-made meal falls by 4%.
- YED = -4 / 8 = -0.5.
- YED is negative, so for these households the meal is an inferior good.
- With more income, they switch to fresher or restaurant food.
Watch out for this
A YED of 0.5 means the good is inferior because it is less than 1.
Any positive YED means a normal good. 0.5 is a normal good that is a necessity. Only a negative YED means inferior.
Check your understanding
A recession is forecast, with incomes expected to fall by 4%. Which seller should expect the biggest fall in sales?
- A cruise operator, whose YED is +2.5.
- A budget noodle chain, whose YED is -0.5.
- A rice wholesaler, whose YED is +0.2.
Show the answer
A cruise operator, whose YED is +2.5.
Right. With YED of +2.5, sales fall about 10% when incomes fall 4%. Luxuries are hit hardest.