Income elasticity of demand (YED)

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Income elasticity of demand (YED): the responsiveness of the quantity demanded of a good to changes in consumer income.

YED allows us to work out which goods are inferior, luxury and normal.

When YED > 1 or <-1, demand is elastic.

When YED is between -1 and 1, demand is inelastic.

When YED < 0, goods/services are inferior. This means as income rises, demand for these goods decreases. (e.g. bus tickets) They vary inversely with income.

When YED < -1, goods are very inferior (e.g. own-brand labels, cheap cuts of meat).

When YED = 0, demand for the good is independent of income.

When YED > 0, goods/services are normal. Demand for these goods vary directly with income, and the state of the economy.

When YED is between 0 and 1, goods/services are necessary. When income increases, demand for these goods go up a proportionally smaller amount (e.g. potatoes)

When YED > 1, goods/services are luxury. The demand for these goods goes up by a larger proportion than any increase in income. (e.g. DVDs) NB: this is a technical term.

Therefore, luxury goods are more volatile, as demand changes dramatically depending on small changes in income.

Inferior goods can also be volatile but are counter-cyclical (demand will increase when incomes fall)

Necessary goods are not very volatile.

Companies that produce luxury or very inferior goods can try to smooth out any volatility by

> Changing prices

> Diversifying offerings (e.g. diffusion lines) or focus on sales in other countries

> Advertising

Terms of trade: relative prices of exports vs imports.

Primary goods tend to be inelastic, as they tend to be necessary goods.

Manufactured goods tend to be elastic, as many are luxury goods.

Therefore, developing countries tend to have declining terms of trade as, as living standards rise, demand for manufactured goods will rise more quickly than demand for primary goods, so the price of their imports will be greater than the price of their exports.

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