Essay: Income elasticity of demand

(A) The key demand-side drivers of price

The main drives of price of a particular good by demand are as follows:

1. reduction/ increase in income
2. reduction/ increase in the price of a substitute/ complement
3. fall/ improvement in consumers’ preference for the product
4. price expectations

Each force behind the shift in demand and price are discussed briefly in the following sections.

Reduction/ increase in income: With the increase in consumers’ income, the demand for income-elastic good, such as housing, tends to increase accordingly. But when incomes are likely to fall, the consumer will cut back on such good which are not essential to them, e.g. Australian wine. Thus the growth or recess in economic will effect the willingness to demand and in turn the price of the good. But effect of income on the normal good and inferior good usually differs.

A good indicator of the relationship between the demand and income is Income elasticity of Demand, which is a ratio of percent change in demand per percent change in income. Normal goods, either normal necessities or normal luxuries, have a positive income elasticity of demand. On the other hand, Inferior goods have a negative income elasticity of demand[1].

India’s total import of edible oil during November 2008 to October 2009 is reported at 81.83 lakh tons compared to 56.08 lakh tons last year and 47.15 lakh tons in 2006-07, to which one of the reason is the rise in income[2]. Another example of normal good is international air travel. The following chart shows clearly the relationship between the GNP and ASK (Available Seat Kilometers) for 77 countries with Singapore, Hong Kong, US and Switzerland above the trend line. It is to be noted that GNP is only one of the factors, such as wealth, size, and isolation of country, and the propensity to travel by air, affecting this trend[3].

Although the Income Elasticity of Demand is a convenient indicator, it not alone suffices in judging the true relationship between the income and the demand, because within a given market, the income elasticity of demand for various products can vary and of course the perception of a product must differ from consumer to consumer. What to some people is a necessity might be a luxury to others[4]. The simple interpretation of a product as income elastic or not can also be a controversial subjects among different analysts[5],[6].

Although it is the conventional acceptance of demand for services as income elastic, more in-depth researches are required to evaluate for each particular country or market[7] .

Reduction/ increase in the price of a substitute/ complement: The reduction or increase in price of good by one producer may shift the demand curve for its competitor. Being price promotion a common way of increasing demand and market share will result in reduction of price among various competitions.

The rise and fall of demand for a particular good will lead to increased or decreased demand for its complement products, resulting in increase or decrease in price of both products until they reach their equilibrium.

The effect of the changes in price of a substitute or a complement to a product on its demand (quantity) is usually measured by Cross Elasticity of Demand, which is the ratio of percentage change in quantity demanded to percentage change in price of a substitute of complement. The cross elasticity of demand is positive for a substitute and negative for a complement[8].

With the fall of gas prices, which are complement good to conventional cars, consumers’ priority of buying a hybrid, a substitute for fossil fuel-only cars, fell off quite quickly[9]. The soaring price of fuel can trigger cancellation or postponement of aircraft orders[10]. The effect of a good advertizing program on cross elasticity of two competing products can be seen in the rise of market share Molson Canadian beer and the fall of its compotator Labatt. The “I am Canadian” advertising campaign[11] made the market share of Molson Canadian beer increased by 3%, while that of Labatt’s its largest competitor, shrunk by 3%[12].

Fall/ improvement in consumers’ preference for the product: A positive improvement in tastes and preference for a product, which may be due to the influence of advertising, will drive the demand for the product. With increasing demand and the supply lagging behind will lead to higher price to keep the equilibrium.

The taste and preferences of consumers change over time. The main factor effecting the consumers’ preferences are positive or negative report on the products, advertizing, changes in life style and trend, and custom and habit. For example, the increase in volume of juice production and utilization can be explained by[13]:

1. consumer’s preference for non-alcoholic drinks due to an increasing awareness with regard to health;
2. change in lifestyle with a tendency to prefer natural and “healthy” products;
3. campaigns against alcoholic beverages;
4. stronger drunk driving laws;
5. an increase in purchasing power leading to greater sophistication and diversification of drinks;
6. a multitude of product innovations, particularly innovations concerning packaging and distribution.

Price expectations: Higher or lower price expectation in the future will move the position of the demand curve to left or right from its previous equilibrium positions, effecting the rise or fall of the price of the good. It is specialty true with constant slope of supply curve. With the expectation of the fall in price in the future, the consumers hold back their purchase, and the inverse is true when they believe that in the future prices will rise.

This effect can be seen in the rise of the HDB resale prices with the feverish buying activity, called panic buying, fuelled by recent positive economic sentiment. Chesterton Suntec International’s research and consultancy director Colin Tan said that with resale prices surging upwards, more people are buying earlier in anticipation of more price increases. ‘The problem is, many buyers put off their purchases during the height of the recession. As resale prices start to run up, panic sets in and buyers, including PRs, start to buy at all costs, which adds further to the demand,’ he said[14]. A model by David Miles[15] published in 2006 assumed that the expectation of price rises led to further prices rises, because the anticipation of a capital gain from higher property prices makes the prospect of owning property even more appealing. As such, rising house prices fuel demand for house purchase[16].

The effect of the above factors will make a shift of the demand curve, and it will in turn make the price shift. The effect can be seen clearly seen in the following demand- supply curve.

The factors, which were discussed above, shift the demand curve to the right of left of its original position. And with the supply curve of the product remain at its original position; the price of the product will change according to the new position of the demand curve.

(B) The effectiveness of a price discount in raising revenues during recession

During current economic recession, many companies, willingly or sometimes forced to, lower the price of their products in order to maintain their market position, customer loyalty and thus relatively stable level of revenues. The magnitude of price discount a company can implement depends much on the price elasticity of the demand of a particular product, and the level of the product image.

The following illustration explains how the elasticity level of a product affects the amount of extra demand it can create.

The product B in the Figure 2 shows more elastic behavior than that of product A, i.e. eB > eA, where eB and eA being elasticity value of product A and product B respectively.

The interpretations of the charts in Figure 3 are as follows:

1. For the same changes in price, the product B will generate higher percentage of demand than that of product A. (Figure 2a and 2b)
2. Likewise, to get same amount of increase in demand, the product A will have to make higher percentage of changes in its price. (Figure 2a and 2c)

The classic example of inelastic is Coca-Cola with relatively less responsiveness of demand to its price changes. On the other hand, the mobile phone plans are good example for their elasticity, the sudden change in prices will induce the loss of number of subscribers to a rival company. With the findings from Figure 3 and the nature of elasticity of the products, companies can design their discount plans to be effective and to reflect the business environment and current economic situations. Other than level of the product’s respond in price-demand curve, the brand position is also important in deciding whether to go cheap and to what level[17].

One of the ways to sell the products at discounted price is to produce more at lower marginal cost, thus maximizing the marginal revenues. With lower marginal costs, the firm will be more able to maximize profits at a higher level of output[18].

The common guide[19] for a recession discount plan is defined below.

1. Avoid damaging consumers’ perception of the products associated with discounted “cheap price”, e.g. as in the case of Apple products.
2. Avoid treating consumers as “scroungy skinflints”, e.g. in the message in the ads for rebranding of the products for the recession.

The types of discount plan a company can make to enhance the performance and to overcome the limit of less elastic products are:

1. Bundle products or services to add value, i.e. to make attractive value for the customers, e.g. bundle solutions from mobile carriers. (M1’s lack of ability to offer bundled services, SingTel’s market gain due to its ‘aggressive’ handset discounts and an exclusive deal for the highly coveted Apple iPhone)[20]
2. Alliance between air lines to cut costs, and thus to offer competitive price
3. Usage of open source operating systems likes Linux for new line of Netbooks with relatively low price
4. Rather than lowering down the price of high-end items, promoting discounts on low-end products will boost the demand (PearlParadise.com, an online retailer in Los Angeles)[21]
5. Limited discounts, instead of entering a price war with competitors, can boost sales without branding the company as a discount seller (ePromos Promotional Products, a New York City-based seller of logo-imprinted corporate gifts)[22]

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References

[1]Tutor2u. Income Elasticity of Demand [online]. Available: http://tutor2u.net/economics/content/topics/elasticity/income_elasticity.htm [accessed 24 November 2009]

[2] CommodityOnline, (2009). India’s vegetable oil imports surge 37% in 2008-09 [online]. Available: http://www.commodityonline.com/news/Indias-vegetable-oil-imports-surge-37-in-2008-09-23019-3-1.html [accessed 24 November 2009]

[3] National Geographic Greendex, (2009). Greendex 2009: Consumer Choice and the Environment � Market Basket Report [online]. Available: http://www.nationalgeographic.com/greendex/market_basket.html [accessed 24 November 2009]

[4] Tutor2u. Income Elasticity of Demand [online]. Available: http://tutor2u.net/economics/content/topics/elasticity/income_elasticity.htm [accessed 24 November 2009]

[5] The Economist, Free exchange, (2007). Prostitution index [online]. Available: http://www.economist.com/blogs/freeexchange/2007/03/prostitution_index.cfm [accessed 24 November 2009]

[6] The New York Times, Opinion, (2008). What Do Prostitutes and Rice Have in Common? [online]. Available: http://freakonomics.blogs.nytimes.com/2008/12/16/what-do-prostitutes-and-rice-have-in-common/ [accessed 24 November 2009]

[7] International Economic Journal, (Vol. 16, No. 1, p 95-104, Spring 2002). How Income Elastic is the Consumers’ Demand for Services in Singapore? [online]. Available: http://www.iejournal.com/02spring/02-S5.PDF [accessed 24 November 2009]

[8] The Wandering Soul, (2008). Elasticities of Demand and supply [online]. Available: http://purple786.wordpress.com/2008/08/24/elasticities-of-demand-and-supply/ [accessed 24 November 2009]

[9] Los Angeles Times, (March 17, 2009). Hybrid car sales go from 60 to 0 at breakneck speed [online]. Available: http://articles.latimes.com/2009/mar/17/business/fi-hybrid17 [accessed 24 November 2009]

[10] The Times, (July 14, 2008). Threat to aircraft orders as fuel prices soar [online]. Available: http://business.timesonline.co.uk/tol/business/industry_sectors/engineering/article4327146.ece [accessed 25 November 2009]

[11] Wikipedia, (2009). I Am Canadian [online] Available: http://en.wikipedia.org/wiki/I_am_Canadian [accessed 25 November 2009]

[12] Welker’s Wikinomics, (2009). The role of advertising in determining price elasticity of demand [online]. Available: http://welkerswikinomics.com/blog/2009/10/20/im-proud-to-be-a-canadian-and-i-like-beer/ [accessed 25 November 2009]

[13] Baourakis G., Baltas G., Izmiryan M and Kalogeras N. (2007), Brand preference: a comparative consumer study in selected EU countries, Operational Research, An International Journal, Vol 7, No. 1.

[14] Straits Times, (Mon, Oct 26, 2009). HDB resale prices at record high by Jessica Cheam [online]. Available: http://www.asiaone.com/Business/My+Money/Property/Story/A1Story20091026-175906.html [accessed 26 November 2009]

[15] UK Housing: How did we get here? Miles. D, Morgan Stanley Research, 2006

[16] The Building Societies Association, UK. (2007). House Price Expectations: An insight into how people think about property purchase [online]. Available: [accessed 26 November 2009] http://www.bsa.org.uk/publications/industrypublications/house_price_expectations.htm [accessed 26 November 2009]

[17] Drew’s Marketing Minute, (2008). Should you lower prices during a recession? [online]. Available: http://www.drewsmarketingminute.com/2008/02/marketing-durin.html [accessed 19 November 2009]

[18] Begg, David, and Damian Ward. Economics for business. 2nd ed. 2006-12-01, 2006. 98-100. Print.

[19] Alberta Venture Magazine, (2009). Action Plan: Steal Market Share in a Recession [online]. Available: http://www.albertaventure.com/management/action-plan-online-part-7-of-10/ [accessed 19 November 2009]

[20] The Straits Times, (Feb 28, 2009). More switch to SingTel [online]. Available: http://www.straitstimes.com/Breaking%2BNews/Singapore/Story/STIStory_344121.html [accessed 26 November 2009]

[21] Inc Magazine, (2009). Pricing: How Low Can You Really Go? Businesses reexamine their prices [online]. Available: http://www.inc.com/magazine/20090301/pricing-how-low-can-you-really-go.html [accessed 19 November 2009]

[22] Inc Magazine, (2009). Pricing: How Low Can You Really Go? Businesses reexamine their prices [online]. Available: http://www.inc.com/magazine/20090301/pricing-how-low-can-you-really-go.html [accessed 19 November 2009]