May 2013/HP1(TZ2)/Q2
[PAGE 142] Explain the importance of income elasticity of demand for the producers of
primary products, manufactured goods and services
Income elasticity of demand (YED) measures the degree of responsiveness of demand
for a good in response to a change in income, ceteris paribus. YED involves a shift in the
demand curve in response to changes in income. Producers are defined as someone who
creates and supplies goods and services.
YED allows producers of primary products to predict their demand to a certain
extent and take appropriate policies to increase total revenue. Primary products are natural
resources that have not been manufactured. In a growing economy, primary producers of
income-inelastic primary goods with a low YED are likely to experience small increases in the
demand for their products. Increases in demand for primary goods can be attributed to the rising
population and those who are still relatively poor despite the higher incomes. The knowledge
that consumers will likely not increase their demand for primary goods to a significant extent
could help primary products producers ensure that they do not overproduce in reaction to higher
wages. On the other hand, a low YED means that the demand for primary products decreases
less than proportionately to a fall in income. The knowledge of YED informs producers that there
is less of a need to cut back on production excessively in the event of a drop in income.
Manufactured goods are man made products that have undergone processing and are
produced by the secondary sectors. In the event of economic growth, the rising incomes and
growing purchasing power of consumers will most likely lead to an increase in demand for
luxury items, such as jewellery, as opposed to basic commodities like rice. Most consumers are
more likely to spend a significant portion of their increased income in luxury gods, and some
consumers might even spend less on inferior goods. With that said, the shift in demand is still
relative to the income base of the economy. If people are still relatively poor, they are likely to
spend a significant portion of their income on necessities despite the increased income. Firms
can also plan for increased sales during periods of rising incomes, so as to maximise profits.
Conversely, a recessionary phase will lead to a drop in demand for luxurious manufactured
goods, as people experience a drop in income, causing them to cut back on non-essential
spending. Producers of manufactured goods can make plans for expansion during period of
economic growth and reduce stock in a recessionary period.
Services are economic activities where immaterial exchange of value occurs, and are
considered tertiary products produced by the tertiary sector. Majority of people residing in
developed economies work in the tertiary sector. A rise in income will make luxury items more
affordable, including services. This is because people are more likely to treat themselves to
restaurant meals and spa services once their basic necessities have been satisfied. For
example, massage parlours and nail salons have blossomed in developed countries such as
United Kingdom, where there is a large population of relatively wealthy individuals. Service
providers can use their knowledge of income inelastic demand for services to make suitable
production plans, such as increasing production during expansionary periods and cutting back
during a recessionary phase. Alternatively, service providers can differentiate their services from
competitors by making their services more attractive through advertisements or additional and
improved service production.
In conclusion, the importance and extent of significance of YED differs for various
products, depending on whether the product is a normal or inferior good, and if it is price elastic
or price inelastic. Although certain applications of YED may involve business strategies which
help generate higher total revenue, these strategies may also incur higher costs. Ultimately, it is
up to producers’ own discretion to choose a strategy that will allow for profit maximisation.
Furthermore, firms should also consider the uncertain and constantly fluctuating nature of
national income, and take into account the effects of income changes on the pattern of demand
for their products.