 Hello and welcome to this session in which we will discuss the income elasticity of demand. The income elasticity of demand measures the responsiveness of quantity demanded for goods or service to a change in income. Well simply put we're looking at the change in quantity, change in queue as the change in income occurs. So as you change in income up or down how would that affect your demand on the change of the quantity? It helps understand how sensitive is consumer demand to a change in income. So if there is a change in income how is that income going to change the quantity demanded? Now this computation is important on many on many levels. It's important for businesses, policymakers and economists. Simply put this ratio would help predict the consumer behavior. What we're trying to find out is if income went up for a particular group of people how would that increase or decrease in income for that matter affect the change of quantity for a certain product? If I'm a business I want to know if income overall goes up how is that going to affect my product or if income goes down how is that how is going to affect my product and this is what we'll be discussing in this session. So let's go ahead and get started with looking at the formula for income elasticity. Before we proceed any further I have a public announcement about my company farhatlectures.com. Farhat accounting lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead start your free trial today. The formula is the change the percentage change in quantity demanded the percentage change in quantity divided by the percentage change in income and I hope this is not a surprised formula for you if we looked at price elasticity of demand of supply basically a similar very very similar formula same thing with cross elasticity remember the quantity is always in the numerator so this ratio this income elasticity can be positive and can be positive usually positive for normal goods we're going to see what normal goods is and we're going to understand what that's a positive mean it means when you compute this ratio the answer is positive this ratio could be negative and usually it's negative for inferior goods or it could be zero zero means the demand approximately remain the same with the change in income basically no effect so it's it's going to provide insight in the nature of a good or a service also by looking at this whether it's positive or negative it's going to help us whether the goods we are dealing with is a normal inferior or luxury for that matter we'll look at all of those starting with normal goods what do we mean by normal goods normal goods are goods for which our demand increases as our income increases so any goods anything you would like to buy more of as your income goes up as your income goes up okay if you if you're demand the queue for that product goes up we call it normal goods now for example if you have more money you might want to buy a better car a more luxurious car you're going to spend at a high-end places this is what we mean by normal goods okay so in this case the income elasticity of demand is positive greater than zero and we're going to measure this for example a good example will be luxury cars if a person income increases by 10 and as a result you mean a person's income means the overall society's income or a particular group of people and the quantity demanded for luxury goods increased by 20 percent we say the income elasticity of demand is 20 the change in quantity divided by the changes income is 2 this indicate that luxury cars are income elastic it means as you make more money as you make more money you want to buy more of that goods so your income only increased by 10 percent the demand increased by 20 percent so as your income goes up you demand more of that product if that's the case it's normal goods most goods are normal goods because most goods assuming you want to buy more of them they are called normal normal goods this is what we mean by normal goods now let's talk about inferior goods inferior goods are those for which demand decreases as income increases so as your income goes up your demand for that product goes down the income elasticity is negative less than zero it's it will be negative an example will be a low cost low cost product now my classic example when I learned this about inferior goods versus normal goods I still remember my my econ professor dr. Bajua he said that as you make more money you're gonna be buying more of steaks and lobsters and less of eating less at McDonald's and back then I loved McDonald's I said no way I was a recent immigrant in the United States I tell the story every time I talk about inferior goods I say no way as I make more money I'm gonna eat more at McDonald's that's not true as you make more money you will stay away from places like McDonald's for one thing it's not healthy two you get sick of it after a few days but back then you know I did not eat I did not eat on a regular basis added but once you can you'll get sick of it really quickly so McDonald's will be considered inferior goods in a sense that as your income goes up you will demand less of it so if a person increases by 10% but the quantity demanded for some generic product increases by only 5% so as your income goes up as your income goes up the quantity demanded for that product is negative goes down then the coefficient is negative 0.5 this negative value suggests that the generic product are income and elastic as the rise in income leads to the decrease in demand again this is a classic example of inferior goods also we have to look at the goods from a perspective of necessities versus luxuries necessities and luxuries can also influence how the income elasticity the income elasticity of demand necessities and we're talking here about food food or basic clothing then tend to have income elasticity between zero and one indicating that the quantity demand that increases but at a slower rate than income so usually if you have if if the coefficient is between zero and one it is positive but it's not growing at a fast rate but if the income is greater than one it's growing at a faster rate so when it comes to food even if you make more money how much are you going to buy in food or in clothing as long as the clothing is considered necessity not that much now you might you might start to buying brand names that's totally different but basic clothing it's going to be the same basic food it's going to be the same luxuries on the other hand have income elasticity greater than one indicating that the demand for those increase at a faster rate as your income increases the demand for those increase at a faster rate for example if a person's income rises by 10% and the demand for vacations increase by 30% the income elasticity will be equal to three suggestion that a lot like vacation consider a luxury but if your income increases by 10% you are not going to increase your food intake by 30% but your spending on vacation might increase by 30% let's take a look at a few other examples to just kind of complete the picture here suppose we have a market for smartphone and we want to determine the income elasticity for the smartphone and let's assume the average income is 50 000 per year and the average quantity demanded for now is 10 000 units 10 000 cell phones okay let's assume there's an increase in income from 50 to 60 000 the economy picked up and everyone's average income increased from 50 to 60 well what's that increase from 50 to 60 that's a 10 000 I will take the difference divided by the original and that's a 20 increase however the quantity demanded for the smartphone was 13 000 so that's 3000 the difference is 3000 divided by the initial starting point 10 000 so the increase is 30 000 immediately what do we see we see that the increase and the quantity demanded is faster than the increase in income the percentage so the quantity demanded increased by 30 percent this is how we compute this the change then divide by the initial value the change in income the change divided by the initial value of then of 50 000 is 20 percent when we compute income elasticity we find out a change in quantity percentage of change in quantity divided by the percentage change of income the answer is 1.5 what does 1.5 mean one thing it's positive it's elastic and it's more than one it's more than one the income elasticity of demand since the value is greater than one we conclude that smartphones are luxury goods okay this means that a one percent increase lead to a 1.5 percent increase in the quantity demanded of smartphone okay there's a strong relatively strong responsive of demand and changes in income now why how do we use this information this is valuable for companies that manufactures and market those smartphone so they can understand the consumer behavior so if they see our incomes going up they might want to increase their advertising so let's take a look at an example for an inferior good and let's assume we are dealing with cheap brand of instant noodles and when I was in college I used to buy those in the dozens because I did not have money each package would cost me 25 cent now let's say the average income of the consumer increased by 15 percent from 25 000 to 28 000 750 however as their income increases the demand for cheap instant noodles decreased by 10 percent so let's see how it works the quantity demanded went from 5000 to 4500 a decrease by 10 percent and their income increased by 15 so the quantity demanded went down by 10 income increased by 15 percent we're looking at an inferior good now let's compute this income elasticity of demand is negative 0.66 well this tells us that the demand for cheap noodles is income and elastic and negative meaning that it's an inferior good the demand decreases okay the demand decreases as the income increases as the income increases and it's less than zero it's less than zero it's the demand for the product is decreasing okay now bear in mind because the absolute value of the answer is 0.66 less than one okay less than one the absolute you know negative 66 the absolute value of that is 0.66 which is less than one the change is not as strong as the change in income so yes we have less demand for this but it's not at the the change is not as high okay so yes we are consuming less of cheap instant noodles but not you know you know if it was negative two or negative three then the change would have been more uh directional but it's not it's it's a slight change it's a slight change yes you cut down on your noodles but by not that much okay maybe if your income goes up further if the income of this group of people goes up further and further you know double to fifty thousand then you might cut down substantially on noodles maybe the the uh the five thousand packets would only have one thousand of them that that that are being purchased so anything that's between negative one and one so if you have zero negative one and plus one so there will be a change but the change the directional is not it's not strong okay anything above one or below negative one well the change is relatively strong relatively strong what should you do now go to far hat lectures and look at additional mcqs that's going to help you understand this topic better the only reason you are going to understand it is to test yourself 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