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Define and explain the concept of an income elasticity of demand for a product

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  1. What is the income elasticity of demand and why it is so important?
    1. Definition and formula
    2. Why is the income elasticity so important?
  2. Cases study: potatoes and DVDs
  3. The example of oil

Would you expect the income elasticity for potatoes and DVDs to be large or small? If the supply of oil is price inelastic in the short term, what would you expect the impact of an outwards shift in the demand for oil to be? What might happen in such a situation in the long term? In economics we usually perform a partial equilibrium analysis. Thus, while assuming that all other markets remain constant, we observe only one. We can then observe the changes in supply, prices and demand within this market. However, this is just an indication of the general features of the current trends. It does not define the exact percentage of an increase or decrease in demand. To overcome these shortcomings, economists are now using the tool of elasticity of demand, as it measures the percentage by which demand will alter if there is a change in price, income or supply. Thus there are three types of elasticity. In this document, we will concentrate on the income elasticity of demand as it is the parameter that is consulted when choosing what to produce. At the outset, it is important to define and explain the income elasticity of demand with examples, along with its definition, its formula and the reasons for its relevance. We will then study the specific cases of the demand for potatoes and DVDs, which are two radically different types of goods. To conclude, we will analyze the demand for oil when the supply of oil is price inelastic in the short term, and then study the effects in the long term.

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