Lesson 6 23 (Part 2) Income Elasticity of Demand and Price Elasticity if Supply

Income Elasticity of Demand – Section 3.2 of your text

From your syllabus

Income elasticity of demand (YED)

= % change in quantity demanded/ % change in income

Income elastic demand (services and luxury goods) and income inelastic demand (necessities)

Significance of sign

- Positive YED (normal goods) and negative YED (inferior goods)

- Less than one (necessities) and greater than one (services and luxury goods)

So, recall we have just looked at the idea of how responsive a change in quantity demanded is to a
change in price. If it is ‘more than proportionately responsive’ we call it price elastic., and if it is ‘less
than proportionately responsive’ then it is price inelastic. Now that we have that clear, let’s look at
another responsiveness – responsiveness of the quantity of a good consumed to a change in the
income we receive. This is defined more comprehensively on page 98 of your text. Copy that
definition into your book and attempt to understand it.

Now look at the formula for income elasticity on the same page and work through the example in
your text.

Now try the following example from the November 2022 Paper

Answer
Interpreting Income Elasticity

We look for two pieces of information from YED:-

1. The sign value ( + or - )

2. The numerical value relative to 1.

1. If the income elasticity is positive, then this suggests a direct relationship. This is a normal
good. That is, we consume more of it as income increases. If the income elasticity is
negative, we call this an inferior good. We demand less as we get higher income.

Can you think of what type of good may be inferior?

Examples: Bus rides, used clothes, used cars.

2. If a good has a YED less than one we define that as ‘inelastic and a ‘necessity’. If it is greater
than one we regard it as elastic and a ‘luxury’. Rather counterintuitively, what comprises
each can differ depending on your absolute income level. Discuss this with your teacher. If
it is equal to 1 it is unit elastic.

Here is your usual cheesy Youtube clip on all of this!

Now read through all of Section 3.2 up until test your understanding 3.7. Complete test your
understanding 3.7. Here are the solutions to the numerical questions.
Below are some activities to complete. Here are the solutions to these activities.

Activity 1
Watch this video on YED and then complete the activities that follow:
(a) A worker is awarded a 10% pay rise (after taxes have been deducted). In response the
consumer cancels their cheap £ 30 a month membership at a sports club and upgraded to the
premium membership, which costs £ 40. Calculate the YED
for premiers
hip sports club package?
(b) Describe the YED of this good.
(c) Complete the diagram above, by adding the appropriate labels.
(d) Complete the missing summary by filling in the missing words:
As a general rule basic necessity items are income or YED________, meaning that the resulting
% change in quantity demanded is ________ than the initial change in real income. By contrast
luxury goods are normally YED ________. This means that the resulting % change in quantity
demanded is _________ than the initial change in real income. Other products may be unitary or
unit elasticity. This means that the resulting % change in quantity demanded is ______ to the
initial change in real income. These goods are neither luxury goods or basic necessities and
examples might include second hand cars or medium luxury products.

Here is another:_

Activity 2
1. The following table documents the relationship between sales of new cars in the USA and
income levels:
a. Complete the missing blanks at the bottom of the table - (numbers in brackets indicate
negative values).
 Year Real GDP growth (%) Growth in new car sales (%)

August 2006 2.39 1.49

August 2007 1.87 (8.72)

August 2008 (2.77) (8.11)

August 2009 (0.24) 0.8

August 2010 2.73 (21)

August 2011 1.68 7

August 2012 1.28 20.56

August 2013 2.66 16.28

August 2014 2.49 16.67

Average for the period ____ _____

b. Based on the above figures calculate the level of YED for the new car sales in the USA?
c. Describe the relationship between income levels and new car ownership in the USA?
d. Provide two reasons why the sale of new cars is income elastic.

Activity 3: Inferior goods

Watch the short video and then answer the questions which follow:

Questions:
 The diagram
The diagram above illustrates an inferior good. This is one that has an inverse relationship
between income and demand. As a person's income rises demand for this type of good falls.
(a) Provide some examples of inferior goods or services.
(b) Inferior goods will have a YED lower than _________
(c) Why might public transport be an example of an inferior good?

Activity 4
Which of the following goods and services do you think are examples of inferior goods in the
USA?
Ramen noodles
Bread / bread products
Cheap microwave pizzas
Oil
Public transport
Used cars
Potatoes
Unhealthy foods including junk foods
Supermarket own brand items
Samsung smart phones

Activity 5
Cigarettes have a negative YED in the USA and Europe. Does this mean that cigarettes are
actually inferior goods? What are they inferior to?

Activity 6: Calculating YED

(a) Sarah receives a pay rise and her income rises from $ 40,000 to $ 50,000. As a result of this
she increases her expenditure on holidays from $ 2,000 per year to $ 2,800. She also purchased
a more expensive gym membership which now costs $ 100 per month rather the previous $ 80
per month. By contrast her food expenditures rise only from $ 500 per month to $ 520. She also
calculates that her monthly expenditures on heating her house did not change. Following her
wage rise she spends slightly less on public transport, reducing her monthly expenditure from $
150 per month to just $ 100.
Calculate her YED for
i. Holidays
ii. Gym membership
iii. Food
iv. Heating for her house
v. Public transport
vi. Explain why her expenditure on public transport fell following her pay rise?
Question (b)
Brian loses his teaching position where he earned £2,500 a month and was instead forced to live
of unemployment insurance, where he received just £1,000 a month. As a result he is forced to
cancel his planned skiing holiday and instead stay at home, looking for a new position. He also
decides against purchasing a new car, which would have cost him £10,000 and instead
purchases a cheap second hand model for just £2,000. He also reduces his weekly food bill at
the supermarket by identifying certain supermarket brand products, which he can purchase
rather than the branded items he purchased previously. In total his food bill fell from £400 a
month to £250. As a final cost cutting measure he quits his gym membership and instead takes
up jogging and decides to turn down the heating at his house, reducing his monthly gas bill from
£120 each month to £90. His spending on rent, internet and electricity remain unchanged.
Calculate his YED for:
i. Car purchases
ii. Food
iii. Gym membership
iv. Heating his home
v. Rent, internet, electricity expenses
vi. Explain why he is unable or unwilling to reduce his monthly expenditure on rent, internet and
electricity?
 Now attempt the Elasticity of Income Revision Sheet (or keep it for when you are revising!) and
check the answers.

Try creating your own examples:-

Create 1 scenario with an answer that has a negative coefficient

Create 1 scenario with an answer that has a positive coefficient

YED and Business Decisions

Read this article and then complete the ‘3 Cs’

Price Elasticity of Supply – Section 3.3 of your text

From Your syllabus

 2.6 Elasticity of Supply

Price Elasticity of supply (PES)

= % change in quantity supplied/% change in price

Degrees of PES – theoretical range in values of PES

Determinants of PES (time, mobility of factors of production, unused capacity, ability to store,
rate at which costs increase)

If you get PED then this should not be a problem. This is basically the responsiveness of quantity
supplied to a change in the price of a good or service. The complete formal definition is on page 104
so please get it into your notes.

Also copy and peruse the formula and practise the example in the book and work it through.

Interpreting Price Elasticity of Supply

 Supply is price inelastic when PES < 1

 Supply is price elastic when PES > 1
 Supply is unit elastic when PES = 1

Note the special cases of perfectly elastic supply PES = 0 and perfectly inelastic supply PES = ∞. They
are shown in Figure 3.13. Discuss these with your teacher.

Determinants of Elasticity of Supply

When we are comparing two supply curves on the same scale that intersect with each other we may
call one supply curve ‘more elastic’ than the other if it is a flatter curve. On page 107, they go
through the determinants of elasticity of supply. Go through these with your teacher and complete
the little ‘memory exercise’ involving drawing stick figures.

Now complete the Olive farmers vs children’s toys which is in the PowerPoint to test your
understanding
Then watch the usual video, read all of Section 3.3 and then complete the following tasks checking
against these answers:-

Activity 1

comparison of two businesses

Diagram 1 (above) illustrates the market for children's toys, or indeed many manufactured
products.
(a) Illustrate on the diagram a rise in demand for children's toys. Draw the new equilibrium.
(b) Following the rise in demand for their product, how is the factory owner likely to change her
production levels in response to both higher demand and higher prices?
(c) How easy will this be for the factory owner, presuming that skilled labour and sufficient raw
materials are available to increase production levels?

A comparison with the olive farmer

Diagram 2 (above) illustrates the market for olives, or indeed many agricultural or primary
products.
(a) Illustrate on the diagram a rise in demand for olives. Draw the new equilibrium.
(b) Following the rise in demand for his olives, how is the olive farmer likely to change his
production levels in response to both higher demand and higher prices?
(c) How easy will this be for the farmer?

Activity 2: Other determinants of PES

Describe the impact of the following on the level of PES for any good or service.
(a) The degree to which costs rise in response to changes in output
(b) The level of unused capacity in the production unit
(c) The degree of mobility of the necessary factors of production
(d) The ability of the business to store stock or other raw materials

Activity 3: Degree of elasticity

Place the following descriptions in the box below the arrow, indicating the likely degree of PES
elasticity associated with the statement:
PES inelasticity (PES=0) PES=1
Perfect elasticity (PES=∞)

Goods with a PES close to 0 would be those with ________ spare capacity. They are also likely
to have a ________ production time, use highly ________________ factor resources, such as
skilled labour or scarce resources. They are generally but not always agricultural /
_____________ products.

By contrast, goods with a high PES, will be those where the production facility has
____________ spare capacity. They are also likely to have a ________ production time, use
factor resources, which are easy to substitute, such as ________ labour or __________
resources. PES elastic goods are usually __________ goods or _____________.

Activity 4
Watch the following short video before attempting the short questions that follow:
Questions:
1. Using the formulae % change in supply / % change in price, calculate the PES elasticity of the
following goods and services and state whether each is PES elastic, inelastic or PES unitary:
a. Price goes from 50 TL to 90 TL forcing supply to increase from 60 units to 100
b. Supply rises from 10 – 20 following a rise in price from 10 TL to 50 TL
c. Price falls from 100 – 50 and supply is unchanged
d. Supply rises from 10 – 30 when price rises from 100 TL to 110 TL
Activity 5 – practise questions
1. A computer manufacturer produces computers and increases the price from $ 600 to $ 800.
Following the rise in price, the quantity supplied by the firm, each week, rises from 1 million to 1.1
million units. In the months that follow the weekly output rises further to 1.8 million units
(a) Calculate the level of PES in the short run
(b) Calculate the level of PES in the long run
(c) Explain why the level of PES is greater in the long run than the short run
2. The price and output of coffee beans is included in the table below:

$ per Kg Output (Kgs) PES

4 July 2018 1.60 350 -

13 August 2018 0.93 335

22 October 2018 1.45 345

11 March 2019 0.90 325

a. Complete the table by calculating the PES for coffee

b. Explain why the PES for the crop is PES inelastic
c. Use an explanation of PES theory to explain why the price of coffee fluctuates over relatively
short periods of time?
3. Assign each of the following products to one of the following PES and PED curves - ski
equipment, bespoke shoes, diamonds, tickets for a football stadium, cheap T-shirts and bread:
and complete ‘Test Your Understanding 3.10’

The solutions to the practical questions in 3.10 are:-