Question

The income elasticities of demand for movies, dental services, and clothing have been estimated to be \(+3.4,+1,\) and +0.5 , respectively. Interpret these coefficients. What does it mean if an income-elasticity coefficient is negative?

Short answer

Positive coefficients indicate goods are normal; negatives indicate inferior goods.

Step-by-step solution

Understanding Income Elasticity

Income elasticity of demand measures how the quantity demanded of a good responds to changes in consumer income. It is calculated as the percentage change in quantity demanded divided by the percentage change in income.

Interpreting Coefficients for Movies

An income elasticity of demand of +3.4 for movies means that when consumer income increases by 1%, the quantity demanded for movies increases by 3.4%. This indicates movies are a luxury good, as demand increases more than proportionately with income.

Interpreting Coefficients for Dental Services

An income elasticity of demand of +1 for dental services indicates that when income increases by 1%, the demand for dental services also increases by exactly 1%. Dental services are considered necessities, as their demand changes proportionately with income.

Interpreting Coefficients for Clothing

An income elasticity of demand of +0.5 for clothing indicates that a 1% increase in income results in a 0.5% increase in demand for clothing. Clothing is considered a necessity or essential good, as its demand increases less than proportionately with income.

Understanding Negative Income Elasticity

If an income-elasticity coefficient is negative, it indicates that the good is an inferior good. This means that when consumer incomes increase, the demand for this good decreases. Consumers switch to more preferred alternatives as their purchasing power grows.

Key concepts

Luxury Goods

Luxury goods are items for which demand increases more than proportionally as income rises. This means that as people earn more, they not only purchase more of these goods, but their spending on such items grows at a faster rate than their income increases.

• For example, if a consumer's income increases by 10%, the quantity demanded for a luxury good might grow by 20% or even more.
• This behavior is usually associated with non-essential goods, such as high-end fashion, expensive cars, and premium entertainment options.

The income elasticity of demand for luxury goods is typically greater than one. In our example, movies show an income elasticity of +3.4, which identifies them as luxury goods. When people have more disposable income, they are likely to spend on entertainment, which is not a primary need but adds value to their lifestyle.

Necessities

Necessities are goods that people need for their everyday life. Their demand tends to increase proportionately as consumer incomes increase. This means that even if you start earning more, you will likely buy only slightly more of these goods because they fulfill basic needs.

• Examples include food, basic clothing, and utilities like water and electricity.
• For necessities, the income elasticity of demand is usually close to one but can also be slightly below one, indicating proportional or slightly less than proportional changes in demand relative to income changes.

In the exercise, dental services have an income elasticity of +1, suggesting they are considered necessities. This implies that as incomes increase, spending on dental services increases at the same rate, reflecting their essential nature in maintaining health.

Inferior Goods

Inferior goods are a bit unique. As people's incomes increase, they tend to purchase less of these goods because they opt for higher-quality alternatives instead. This results in a negative income elasticity of demand.

• You might see this with generic brand groceries, cheaper goods, or public transportation, as consumers switch to premium brands and private transport with increased earnings.
• The negative sign of the income elasticity indicates that as people get richer, demand for these goods actually drops.

As an example, if a person's income rises and they move from buying generic brand cereals to premium cereals, the demand for the generic cereal decreases despite their income increase.

Consumer Income

Consumer income plays a pivotal role in determining how much of a product or service is demanded in the market. When there's a rise in income levels, consumers typically feel more financially secure, leading to shifts in purchasing behavior and preferences.

• This change in income impacts different types of goods in varying ways, as identified by the income elasticity of demand coefficients.
• Higher incomes often lead to more spending on both necessities to an extent but primarily on luxury goods, as these are seen to enhance the quality of life.
• With increasing incomes, the demand for inferior goods usually declines, moving consumer preferences towards better alternatives.

Understanding these dynamics gives insights into market trends and consumer behavior, which can guide businesses and policymakers in making informed decisions regarding pricing, production, and economic policies.