The Practical Application of Price Elasticity and Income Elasticity of Demand

There are several uses of Price Elasticity of Demand that is why firms gather information about the Price Elasticity of Demand of its products. A firm will know much more about its internal operations and product costs than it will about its external environment. Therefore, gathering data on how consumers respond to changes in price can help reduce risk and uncertainly. More specifically, knowledge of Price Elasticity of Demand can help the firm forecast its sales and set its price. Sales forecasting: The firm can forecast the impact of a change in price on its sales volume, and sales revenue (total revenue, TR).

For example, if Price Elasticity of Demand for a product is (-) 2, a 10% reduction in price (say, from $10 to $9) will lead to a 20% increase in sales (say from 1000 to 1200). In this case, revenue will rise from $10,000 to $10,800. Pricing policy: Knowing Price Elasticity of Demand helps the firm decide whether to raise or lower price, or whether to price discriminate. Price discrimination is a policy of charging consumers different prices for the same product. If demand is elastic, revenue is gained by reducing price, but if demand is inelastic, revenue is gained by raising price. Non-pricing policy: When Price Elasticity of Demand is highly elastic, the firm can use advertising and other promotional techniques to reduce elasticity.

INCOME ELASCITIY OF DEMAND:

In economics, income elasticity of demand measures the responsiveness of the demand for a good to a change in the income of the people demanding the good, ceteris paribus. It is calculated as the ratio of the percentage change in demand to the percentage change in income. For example, if, in response to a 10% increase in income, the demand for a good increased by 20%, the income elasticity of demand would be 20%/10% = 2.

Interpretation

A negative income elasticity of demand is associated with inferior goods; an increase in income will lead to a fall in the demand and may lead to changes to more luxurious substitutes. A positive income elasticity of demand is associated with normal goods; an increase in income will lead to a rise in demand. If income elasticity of demand of a commodity is less than 1, it is a necessity good. If the elasticity of demand is greater than 1, it is a luxury good or a superior good. A zero income elasticity (or inelastic) demand occurs when an increase in income is not associated with a change in the demand of a good. These would be sticky goods. Income elasticities are closely related to the population income distribution and the fraction of the product’s sales attributable to buyers from different income brackets. Specifically when a buyer in a certain income bracket experiences an income increase, their purchase of a product changes to match that of individuals in their new income bracket.

If the income share elasticity is defined as the negative percentage change in individuals given a percentage increase in income bracket, then the income-elasticity, after some computation, becomes the expected value of the income-share elasticity with respect to the income distribution of purchasers of the product. When the income distribution is described by a gamma distribution, the income elasticity is proportional to the percentage difference between the average income of the product’s buyers and the average income of the population. Many necessities have an income elasticity of demand between zero and one: expenditure on these goods may increase with income, but not as fast as income does, so the proportion of expenditure on these goods falls as income rises. This observation for food is known as Engel’s law.

Types of income elasticity of demand

There are five possible income demand curves:

1. High income elasticity of demand:

In this case increase in income is accompanied by relatively larger increase in quantity demanded. Here the value of coefficient Ey is greater than unity (Ey>1). Eg: 20% increase in quantity demanded due to 10% increase in income.

2. Unitary income elasticity of demand:

In this case increase in income is accompanied by same proportionate increase in quantity demanded. Here the value of coefficient Ey is equal to unity (Ey=1). Eg: 10% increase in quantity demanded due to 10% increase in income.

3. Low income elasticity of demand:

In this case proportionate increase in income is is accompanied by less than increase in quantity demanded.