income+elasticity

Katie Crist Cara Lance David Siberell
 * Definition and Formula**

Income elasticity is a measure of the responsiveness of the demand for a good to changes in consumer income (Baye, page 88). In essence, it is the change in quantity demanded when there is a change in income.

The mathematical formula for determining income elasticity is: __//Percentage change in quantity demanded of good X divided by the percentage change in real consumers' income.//__


 * Normal vs. Inferior Goods**

A good way to measure income elasticity is to look at normal and inferior goods. Normal goods have a postivie income elasticity of demand, so when income rises there is an increased comsumption of these goods. Within the category of normal goods, there is a distinction between necessities and luxuries. Necessities have an elasticity of demand between 0 and +1. As income rises, the demand of a necessity will rise, but at a slower rate. Consumers will want to use the increase in income to purchase luxury items. Luxury items have an elasticity of demand that is greater than +1. When income rises, the demand for luxury items often increases at a rate higher than the demand for necessities. Luxury goods are considered to be "big-ticket items". (http://www.tutor2u.net/economics/content/topics/elasticity/income_elasticity.htm)

On the other hand, inferior goods have a negative elasticity of demand. As income increases the demand for inferior good decrease. Comsumers will opt to spend their money on normal goods. When income falls, consumers will purchase more of the inferior goods. (http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=income+elasticity+of+demand )

The income elasticity of demand has to be considered when firms make forecasts for future sales. If the income elasticity is high, and income increases during the same relative period, then product sales will also increase. If the elasticity is close to zero, then changes in income levels will have little impact on the demand for this product.


 * Ranges of Elasticity**

Inelastic Demand -Quanitity demanded does not respond strongly to changes in price.

Elastic Demand -Quantity demanded responds strongly to changes in price.

Perfectly Inelastic -Quanitity demanded does not respond to price changes.

Perfectly Elastic -Quanitity demanded changes infinitely with any change in price.

Unit Elastic -Quantity demanded changes by the same percentage as the price. ([|http://core.ecu.edu/econ/lid/CH05hand.pdf).]


 * Examples**

Examples of the various types of normal necessities, luxury goods, and inferior goods. Necessities: fresh vegetables and fruits, instant coffee, shampoo, toothpaste, toilet paper Luxuries: international air travel, private education, designer clothes Inferior goods: canned meat, Ramen, frozen fruits and vegetables, store brand items

In many cases, income elasticity has a direct impact on the dietary habits of households. Low income households may reduce their selection of meats and instead focus on less expensive and more starch-based foods. When incomes are higher, regular vegetables are consumed more than frozen, more meat is consumed, and a greater variety of products are stored for later use. Commodities like steak tend to have positive income elasticity of demand while poor grade vegetables have negative income elasticity.


 * Questions:**

1. Joe receives a 20 percent increase in his income from his part time job and as a consequence decreases his consumption of Ramen noodles by 10 percent. Hence to Joe, Ramen noodles are a(n): (a) normal good with a price elasticity of demand of 0.5. (b) substitute good with a cross elasticity of 0.5. (c) good with a price elasticity of supply of –0.5. (d) inferior good with an income elasticity of –0.5.

2. When income increases, the demand for luxury goods: (a) stays the same (b) goes down (c) goes up (d) the demand for luxury goods is not affected by income

3. The income elasticity of demand for chicken noodle soup is found to be -0.7. This means chicken noodle soup: (a) is an inferior good (b) has inelastic demand (c) is a superior good (d) is a normal good

4. If the income elasticity of demand for perfume is 2.4 and incomes are expected to increase by 10% over the next year, how will this affect perfume sales? (a) sales increase by 42% (b) sales decrease by 42% (c) sales increase by 24% (d) sales decrease by 24%

5. Unit elastic is defined as: (a) Quantity demanded does not respond strongly to changes in price. (b) Quantity demanded responds strongly to price changes. (c) Quantity demanded changes infinitely with any change in price. (d) Quantity demanded changes by the same percentage as price.

6. If income increases, which of the following is NOT likely to be purchased for a vacation package? (a) Cruise (b) Resort get-away (c) Air travel (d) Greyhound bus tickets

7. An increase in income means that more will be demanded of what type of good? (a) Substitute (b) Complementary (c) Normal (d) Inferior

8. If tuition increases during the middle of the school year, how does that affect elasticity for tuition? (a) This semester more inelastic, next year elastic. (b) This semester elastic, next year inelastic (c) This semester unitary elastic, near year elastic (d) None of the above

9. The decision to purchase required textbooks for a course: (a) Inelastic (b) Elastic (c) Unitary elastic

10. Your electronics store knows that the income elasticity of widgets is .5. You expect that incomes will drop by 10% next year. How should the purchase of widgets be adjusted? (a) Buy 7.5% fewer widgets (b) Buy 5% fewer widgets (c) Buy 5% more widgets (d) Buy 10% more widgets 11. Consumer incomes have dropped by 7% this year due to a turbulent job market. If your consumption of generic jeans, an inferior good increase by 3%, what is the resulting income elasticity for this good? (a) -.62 (b) -.43 (c) .5 (d) .73


 * Explanation of Correct Answers:**

1. (d) Income elasticity is calculated as -0.10/.2 = -.5 The negative income elasticity tells us that Ramen noodles are an inferior good.

2. (c) Luxury goods are normal goods, therefore when income increases the demand for luxury good increase as well.

3. (a) Since the income elasticity for chicken noodle soup is negative, it is an inferior good.

4. (c) The income elasticity is given at 2.4. Since the percentage change in income is also given at .10 then we know that the change in demand will be .24 because .24 / .10 = 2.4. It is a positive number because with a normal good, an increase in income will increase the demand for the normal good.

5. (d) A good is unit elastic when its elasticity equals 1. Because of this, the percentage change is the same for the change in demand and change in price. 6. (d) Greyhound buses are considered inferior goods because of their level of quality and service. The other packages are more likely to be purchased because of the availability of income.

7. (c) Normal goods are positively correlated with an increase in income. More consumers will demand these products if their income levels increase.

8. (a) This semester more inelastic, next year elastic. An increase in the tuition for this year makes tuition have inelastic demand because the choice to continue education and incur the cost has to be absorbed. The decision for next year is more elastic because the price hike may lead to a decision to pursue education elsewhere.

9. (a) Inelastic. Books have to be purchased because they are at the core of the learning process in that course. If they were recommended, then the demand would be more elastic because their necessity is not as apparent.

10. (b) Purchasing 5% fewer widgets, when divided by the 10% drop, would equate to an elasticity of .5

11. (b) An increase in demand for generic jeans, in conjunction with a drop in income, results in an income elasticity of -.43