2.16 - Importance of YED
The meaning and calculation of income elasticity of demand
Income elasticity of demand (YED) measures how sensitive the demand for a product is to changes in consumers' income.
Calculating income elasticity of demand
Where:
- Percentage change in quantity demanded = The relative change in the amount of a good or service bought (%)
- Percentage change in income = The relative change in consumers' disposable income (%)
Types of income elasticity of demand
- Positive YED (normal goods) - Demand increases as income rises (YED > 0).
- High positive YED (luxury goods) - Demand rises more than proportionately with income (YED > 1).
- Low positive YED (necessity goods) - Demand rises less than proportionately with income (0 < YED < 1).
- Negative YED (inferior goods) - Demand decreases as income rises (YED < 0).
Implications of YED for businesses during economic growth
During periods of economic expansion, when incomes rise, YED influences how markets and businesses perform. Products with higher YED see greater demand increases, prompting strategic responses from firms.
Business strategies for high YED products
Markets for these goods expand more rapidly, so firms may invest in increasing production capacity to meet rising demand.
Business strategies for low YED products
- Producers of goods with low YED might consider switching to products with higher YED.
- Over time, firms in low YED sectors experience slower revenue growth compared to others, potentially contributing to income inequality among producers.
Implications of YED for businesses during recessions
In economic downturns, when incomes fall, YED determines the extent of sales changes. Businesses can use this to anticipate challenges and adjust operations accordingly.
Effects on different types of goods
- High YED goods - Experience sharp sales declines.
- Low YED goods - See smaller sales drops.
- Negative YED goods (inferior goods) - May see sales increases.
Examples of business impacts
- Firms selling essentials with income inelastic demand face milder effects, maintaining steadier revenues.
- In contrast, producers of luxuries suffer larger downturns.
The impact of YED on economic sectors and structural change
As economies develop and average incomes increase, YED drives shifts in the relative importance of economic sectors: primary, manufacturing, and services. This leads to structural changes over time.
How rising incomes affect sector sizes
- Primary sector - Shrinks as demand for basic commodities (low YED) plateaus once basic needs are met.
- Secondary sector (manufacturing) - Initially grows with demand for goods which have a higher YED, but later declines as incomes shift further.
- Tertiary sector (services) - Expands most, driven by high YED for premium services where extra income is disproportionately spent.
Evidence from the UK economy
Since the 1960s, both agriculture and manufacturing have declined in relative terms due to these YED patterns. According to the Office for National Statistics (ONS), services now account for over 75% of gross domestic product (GDP), manufacturing and production less than 21%, and agriculture under 0.60%.