Income Elasticity of Demand

Income elasticity of demand (YED)

A change in income will obviously bring about a change in quantity demanded. But what we do not know is by how much quantity demanded will change.

Income Elasticity of Demand, figure 1

__Definition: ____Income elasticity of demand measures the responsiveness of quantity demanded to a change in income.

Unlike PED, YED can be a positive or a negative answer. Why!? Think about it: what is the ‘normal relationship’ between income and demand? But what about in times of recession when incomes go down and demand for things like your budget supermarkets goes up? It can swing both ways!

INCOME ELASTIC – luxury product, change in income = big change in demand.

YED = >+or-1

UNITARY INCOME ELASTICITY – income change causes the same proportional change in quantity demanded.

YED = +or-1

INCOME INELASTIC – necessity product – change in income = small change in demand.

YED = between -1 and +1 (i.e. a decimal value)

Unfortunately YED is a little more complicated than PED – we consider beyond elastic and inelastic, and consider if it’s a normal (positive YED) or inferior (negative YED) good too.

For most goods/services as income rises the quantity demanded rises (a +ve YED value). Logically correct? We call these normal goods as they have a ‘normal relationship’ with income. But for some goods/services, when income falls quantity demanded actually rises (a –ve YED value – goods that prosper in a recession) and vice-versa. We call these inferior goods.

Exam style question

David’s Choice: Chapman’s or Chic?

Income Elasticity of Demand, figure 1

On 1 March 2011 David Benbow celebrated his 40th birthday and an annual turnover of £150,000 for the first time in his 19 years as an entrepreneur.

On leaving school in 1987, David started work as a technician in Chapman’s Opticians, for what was then a high wage of £300 a week. Before long David realised that this job failed to match his passion for creativity. A year later he started work as a junior stylist in Raymond’s hair salon, Birmingham. Given his commitment to working long hours and a flair for style, David was swiftly promoted, becoming a senior stylist at Raymond’s in 1990. By the summer of 1992 David decided it was time to be self-employed.

Rather than rent his own premises and pay high start-up costs, David rented a chair* in a Stourbridge salon. This gave David the opportunity to learn more about the financial aspects of hairdressing, as he became more familiar with costs and the factors which affect sales income.

In March 2005, once he had sufficient savings, David opened up his own hair salon in the city of Worcester. Advertising costs were negligible because David had developed a strong customer base and reputation in Stourbridge, so clients simply followed him to nearby Worcester. David had also taken advantage of professional development opportunities over the years by paying for courses to update his skills. He did this through formal training with the internationally respected Sassoon Academy in London; David is now one of their partner trainers.

Today David Benbow Hair looks prestigious. Salon prices are by no means as cheap as the £7 charged by a local barber for a dry cut. In this industry David believes “quality counts”, by which he does not simply mean hair treatment. The salon has recently undergone a high specification refit which cost in excess of £40,000, including Italian handmade leather sofas for waiting clients, Shiatsu massage chairs, Italian porcelain sinks, solid oak flooring and LED lighting. David feels his clients are worth every penny. No wonder the salon has featured in Elle fashion magazine.

*Chair = paying the owner a rental fee for the use of part of the salon.

Extract from 2011 Price List

Colour treatmentCut and care treatmentChildren’s treatment
High/lowlights – £90–£105; Colourfull head – £42–£47; Bleachfull head – £30–£35New style – £30–£42; Wet cut – £25–£31; Dry cut – £14–£18£8–£14; 10% off for students and pensioners

Application: up to 2 marks for contextual answers e.g. David’s link to Sassoon makes him different from local competitors, hairdressing is a sector where small businesses can survive due to the importance of customer service and the ability to build strong and lasting relationships with customers

Analysis: 1 mark is available for giving a reason/cause/consequence of why small businesses can survive e.g.

  • May be able to give better customer service than a large organisation resulting in customer loyalty OR

  • The prestige aspect of David’s salon is not something a larger competitor could easily replicate which means that he can build a niche following

1) David has estimated that the price elasticity of demand for his salon is -0.45. He wants to increase the price of his £90 colour treatment to £100 and increase all his prices by the same percentage. Calculate the effect this would have on the number of customers visiting his salon. You are advised to show your working. (4 marks)

KEYWORDS – Knowledge/understanding: 1 mark for defining/using price elasticity of demand

PED = % change in quantity demanded / % change in price

Application up to 3 marks for:

Calculate the percentage change in price

= (new price-old price)/old price x 100%

= 100-90/90 x 100%

= 10/90 x 100% = 11% = 0.11

Re-order formula

-0.45 = % change in quantity demanded/0.11

-0.45 x 0.11 = % change in quantity demanded

= -0.05 = -5%

If answer given is -5% award 4 marks

2) Discuss ways in which David’s salon might achieve a competitive advantage. (8 marks)

KEYWORDS - e.g. focus on a high quality service/experience. Offering waiting clients Italian handmade sofas, handmade sofas will make the client experience more enjoyable which may therefore lead to customer loyalty. HOWEVER, if by providing a better quality experience Shiatsu massage chairs adds significantly to the price of the hair treatments, then some price-conscious customers may be put off going to the salon.

e.g. David’s reputation and the status of being a Sassoon trainer will signal to customers that the product is high quality and the Sassoon link can be used in advertising to highlight ‘international quality’ rather than the salon being just another local salon. HOWEVER, this might deter some customers who might feel that they will be charged ‘London prices’.

3) Assess the factors David would need to take into account when deciding on his pricing strategy (12 marks)

KEYWORDS - Possible factor 1: level of competition. Other hair salons in the local area may impose a limit on the prices David can charge although this will depend on whether they are targeting the same premium segment that David is catering for.

Possible factor 2: costs and need to make a profit. David has decided to spend money on expensive décor and furniture. His prices will have to cover this and also the cost of staff and materials he uses in running the salon.

Possible factor 3: strength of his brand/reputation. David may feel that his reputation will allow him to charge prices above his competitors and indeed might be concerned about the negative impression which might be given by low prices.

Possible factor 4: number of USPs/amount of differentiation. The Sassoon link, the leather sofas, the porcelain sinks – these things set him apart and his may be the only salon offering such features which might allow him to charge more

Possible judgement: because David has positioned himself at the upper end of the market he may not need worry too much on what other salons charge although he cannot assume that demand for his service is completely price inelastic. The external environment could also have an impact – even high end customers can become more price sensitive during an economic downturn.

What is meant by advertising?
Explain how a small business like David’s can survive
Your answer should include: Niche / Differentiation / Unique

Normal and inferior goods

Normal Goods – As income rises, quantity demanded also rises and vice-versa. They have a positive YED value. The classic example is meals out. E.g. ‘normal’ typical goods.

Inferior Goods – As income rises, quantity demanded falls and vice-versa. They have a negative YED value. Consumers switch away from them as rising incomes allot them to buy more attractive alternatives. The classic example is supermarket value lines. E.g. Lidl, public transport, ready-meals etc.

Factors that affect the degree of income elasticity

- Luxuries = income elastic = high YED value (YED = >+OR-1). Tend to have high positive YED values (positive = normal relationship). If real incomes rise, the demand for luxuries (fast cars, luxury holidays and high-tech electrical items etc) tends to rise at a proportionately greater rate.

- Necessities = income inelastic = decimal YED (YED between -1 and +1). Tend to have a low positive (normal good) YED – if income falls then demand will only decrease slightly as consumers will see little alternative beyond the necessity.

  • Of course __what constitutes a luxury/necessity is subjective and can vary __– e.g. in the past mobiles were a luxury but now smartphones have an income inelastic relationship.

  • Habits are also slow to change – many foodstuffs have a low YED. Brand loyalty plays a part here!

- Share of income spent on a good is again relevant. E.g. teabags are cheap and have a low YED.

- Confidence/expectations have an important impact on behaviour. Drop in income which is perceived as a temporary blip will have little impact on consumer demand for most products. By contrast, longer negativity post GFC lead to big changes. The gloomy mood led people to cut back on many relative luxuries – thus goods with a high positive YED truly suffered. At the same time – demand for inferior goods flourished (thermal flasks/lunch boxes etc)

Income Elasticity of Demand, figure 1

The significance of YED to businesses

Many businesses have at least some products with considerable income elasticity – they will be affected by long term trends in rising incomes and by shorter term recessions/booms.

  • En mass income changes will affect business (e.g. income tax change or VAT change)

  • Businesses need to react to changes in income and plan accordingly. (eg. recession of 2008 – luxuries goods suffered and inferior goods rose). It’s important to be__ proactive, not reactive__ – e.g. post GFC supplying some ‘inferior own brand’ lines to supermarkets as well as maintaining the original brand on the shelf (e.g. Cornflakes!). This caters for consumers with both low and high income elasticity.

- As incomes/standards of living increase in the long term, consumers expect more and better. Some established products can turn into inferior goods, with consumers switching to better alternatives. E.g. The Youth Hostel Association has evolved.

  • In the long term, producers of inferior goods can decline, diversify or switch to products with positive YED – e.g. ‘The Money Shop’ wants to be a regular bank and BT landline has diversified back into the mobile sector by trying to acquire EE for 12.5 bill!

Practice time:Use the answers provided to self-assess. Remember your 4 mark calculate structure – formula, figure and then answer! It’s vital to show your working out as you get marks for that in the exam. Take a scrap piece of paper and have a go.

Income Elasticity of Demand, figure 1