factors affecting: income elasticity of demand

Cambridge International AS & A Level Economics 9708 – Elasticities of Demand and Supply

2.1 Demand and Supply Curves

• Demand curve (D): shows the relationship between the price of a good and the quantity demanded, ceteris paribus (all other factors unchanged).
• Supply curve (S): shows the relationship between the price of a good and the quantity supplied, ceteris paribus.
• Market equilibrium: the point where D and S intersect; at this price the quantity demanded equals the quantity supplied.
• Shift vs. movement:
  • A movement occurs when the price of the good itself changes – it moves along the same curve.
  • A shift occurs when any other determinant changes – the whole curve moves right (increase) or left (decrease).

Determinants of Demand (six factors)

1. Price of the good (movement along the curve)
2. Consumer income (shifts the curve – see Section 2.2)
3. Tastes and preferences
4. Expectations of future price or income
5. Number of buyers
6. Prices of related goods (substitutes and complements)

Determinants of Supply (seven factors)

1. Price of the good (movement along the curve)
2. Input prices (cost of production)
3. Technology
4. Expectations of future price
5. Number of sellers
6. Taxes, subsidies and regulations
7. Time horizon (short‑run vs long‑run)

2.2 Price, Income and Cross‑price Elasticity of Demand

Factors that affect each demand elasticity

• PED
  1. Availability of close substitutes – more substitutes → higher elasticity.
  2. Proportion of income spent on the good – larger share → higher elasticity.
  3. Degree of necessity – essentials tend to be inelastic.
  4. Time horizon – demand is more elastic in the long run as consumers can adjust habits.
• YED
  1. Nature of the good (necessity, luxury, inferior).
  2. Proportion of income spent – high‑cost items (cars, holidays) usually have higher YED.
  3. Availability of close substitutes – many substitutes can increase the magnitude of YED.
  4. Consumer preferences, cultural status and fashion trends.
  5. Time horizon – in the long run consumers can re‑allocate spending, raising YED.
  6. Stage of economic development – as economies develop, demand shifts from necessities to luxuries, raising YED.
• XED
  1. Degree of substitutability or complementarity between the two goods.
  2. Proportion of income spent on each good.
  3. Time horizon – consumers need time to find alternatives.

Typical examples

• PED – Petrol (few close substitutes, large share of budget) → relatively inelastic.
• PED – Restaurant meals (many substitutes, luxury element) → elastic.
• YED – Luxury cars (high‑cost, luxury) → high positive elasticity.
• YED – Public‑transport tickets (low‑cost, often inferior) → negative elasticity.
• XED – Tea and coffee (substitutes) → positive XED.
• XED – Cars and petrol (complements) → negative XED.

2.3 Price Elasticity of Supply (PES)

Factors that affect PES

1. Time period – supply is more elastic in the long run when firms can adjust plant and equipment.
2. Mobility of factors of production – highly mobile resources (labour, raw materials) increase elasticity.
3. Spare production capacity – firms operating below capacity can increase output quickly.
4. Storability of the product – goods that can be stored (e.g., wheat) allow producers to respond more easily to price changes.
5. Complexity of the production process – simple processes → higher elasticity.

Typical examples

• Fresh fruit (perishable, limited storage) → inelastic in the short run.
• Manufactured cars (large factories, long adjustment time) → elastic in the long run.

2.4 Interaction of Demand and Supply (Equilibrium, Shifts and Surplus)

• Right‑ward shift of demand (e.g., income rises for a normal good):
  • Equilibrium price rises.
  • Equilibrium quantity rises.
• Left‑ward shift of supply (e.g., a tax on producers):
  • Equilibrium price rises.
  • Equilibrium quantity falls.
• The magnitude of the price and quantity changes depends on the relevant elasticities:
  • If demand is highly elastic, a left‑ward supply shift (tax) causes a large fall in quantity and only a modest rise in price.
  • If supply is inelastic, the same tax leads to a large price increase but a small fall in quantity.

Diagrammatic illustration (figure 1)

2.5 Consumer and Producer Surplus

• Consumer surplus (CS): the difference between what consumers are willing to pay and what they actually pay. On a demand‑price graph it is the area above the market price and below the demand curve.
• Producer surplus (PS): the difference between the price producers receive and the minimum they are willing to accept. It is the area below the market price and above the supply curve.
• When a curve shifts:
  • A right‑ward demand shift expands CS (the area between the old and new demand curves) and also expands PS because price rises.
  • A left‑ward supply shift reduces PS (the area between the old and new supply curves) and can reduce CS, depending on the elasticity of demand.

Diagrammatic illustration (figure 2)

Link to Government Intervention (brief)

Elasticities are essential when evaluating the impact of taxes, subsidies, price ceilings and floors. For example, a tax on a good with an elastic demand will cause a large reduction in quantity and a relatively small price increase for consumers, whereas a tax on a good with inelastic demand will raise price sharply and generate larger revenue for the government.

Relevance to Macro‑economics (preview)

In macro‑questions, elasticities affect aggregate demand (AD) and aggregate supply (AS). A change in income elasticity influences how AD responds to fiscal policy, while price elasticity of supply helps explain short‑run versus long‑run AS shifts.

5 Summary Tables

5.1 Comparison of the Three Demand Elasticities

5.2 Typical Elasticity Values for Common Goods

6 Practical Exam Checklist – “Elasticities” Questions

1. State the definition and formula for the required elasticity (PED, YED, XED or PES).
2. Identify the good/service and classify it (normal/inferior, necessity/luxury, substitute/complement).
3. List the specific syllabus‑listed factors that are likely to affect the elasticity of the good in the given context.
4. Explain the direction of the change in quantity demanded or supplied when the relevant variable (price, income, related‑good price) changes.
5. Draw a labelled diagram showing the relevant curve shift (right/left) and indicate the resulting change in consumer surplus and/or producer surplus.
6. If a calculation is required, use the percentage‑change (arc‑midpoint) formula and show each step clearly.
7. Conclude by commenting on the likely incidence of any tax or subsidy, using the size of the relevant elasticity.