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REG.NO. : 15/2/316/W/1062







Explain the relevance of the concept of income elasticity of demand in executing the roles of the
distribution and allocation branches of public finance
Income Elasticity of Demand is the ratio of percentage change in the quantity demanded of a
commodity to the percentage change in income.

Lipsey defines as the responsiveness of demand for a product to changes in income is termed
income elasticity of demand. Income Elasticity of Demand: is the relative response of demand to
changes in income, or the percentage change in demand due to a percentage change in income.
This elasticity quantifies the buyers' income demand determinant.

Thus it is denoted as follows: Ep = Percentage change in demand in quantity / Percentage change

in income

= (Q / Q) / (Y / Y) = (Q / Q) x (Y / Y) = (Q / Y) x (Y / Q)

Measuring Income Elasticity of Demand

To measure income elasticity of demand, certain determinants are there to be considered. They are
as under.

Natures of Commodity - There are certain aspects which decide the income elasticity and they
are necessities, comforts and luxuries.

Income Level - The category of certain goods depends upon the level of income. For instance,
Purchase of four wheelers may be requirement in a posh country whereas luxury in
underdeveloped countries.

Time Period - With the change in the time frame, a luxury of today may be become requirement
of tomorrow.

Demonstration Effect - Based on effective demonstrations such as expressing, displaying and

exhibiting goods, the likings and fondness of customers changes which ultimately brings about
change in the income elasticity of demand for a variety of goods.

Frequency of Increase in income - Based on the increase or decrease in the income frequency,
the income elasticity of demand varies and based on which tendencies of purchasing luxury goods
is determined.
The concept of income elasticity of demand plays a number of vital roles in executing the
roles of the distribution and allocation branches of public finance and these are;

The concept of income elasticity of demand is useful to a government if the government is

setting prices for goods or services. A good example of this is the minimum wage. The law of
demand tells us that consumers will buy less of a good or service when its price rises. However,
the law does not tell us how much less they will buy. This is where price elasticity of demand
comes in: it is a measure of how much the quantity demanded will change when price changes.

Useful for classification of normal & inferior goods: The concept of income elasticity of
demand can also be used to define the normal and inferior goods. The goods whose income
elasticity is positive for all level of income are termed as normal goods. On the other hand, the
goods for whose income elasticity is negative beyond a certain level of income are termed as
inferior goods.

Resource redistribution; Luxury items represent a very specific group of goods and their supply
is addressed to particular type of consumers, consumers from the top of income distribution.
Unlike necessities, individuals buy luxuries not only for their intrinsic quality but also to confirm
social status. By consequence, demand structure for luxury goods differs from demand structure
for ordinary goods. Decision to purchase a luxury good depends, beyond preferences and income,
on the purchase decision of the relevant others and hence on the socio-economic structure of
society. Luxury good increases with income gap between the two socio-economic groups on
destination market. In addition, individuals in a society with larger income disparities are willing
to pay more for luxury goods. The higher willingness to pay in countries with higher income
disparities is reflected in higher prices of luxury goods in these countries.

Taxation; as David Ricardo, a British economist in the 19th century said, Taxes on luxuries have
some advantage over taxes on necessaries. They are generally paid from income, and therefore do
not diminish the productive capital of the country. If wine were much raised in price in
consequence of taxation, it is probable that a man would rather forego the enjoyments of wine,
than make any important encroachments on his capital, to be enabled to purchase it. They are so
identified with price, that the contributor is hardly aware that he is paying a tax. But they have also
their disadvantages. First, they never reach capital, and on some extraordinary occasions it may be
expedient that even capital should contribute towards the public exigencies; and secondly, there is
no certainty as to the amount of the tax, for it may not reach even income. A man intent on saving,
will exempt himself from a tax on wine, by giving up the use of it. The income of the country may
be undiminished, and yet the State may be unable to raise a shilling by the tax.

Controlling inequality: now imagine the government wants to raise the minimum wage. The law
of demand tells us that employers will pay for fewer hours of labor if the price of that labor goes
up, but we need to know for how many fewer hours they will pay. This might determine whether
the government believes it will be a good idea to raise the minimum wage by a given amount. If
the government knows the price elasticity of the demand for labor, it might be able to figure out if
the benefits of raising the minimum wage will outweigh the costs.

Income elasticity of demand might be useful to public finance as they consider tax and
spending policies. Income elasticity of demand is a measure of how much the quantity demanded
of a good or service changes when consumers incomes change. Governments can have an impact
on the incomes of their citizens. They can, in essence, increase peoples incomes by reducing
taxes and/ or increasing certain facets of government spending that create jobs or reduce citizens'
personal expenditures. They can decrease those incomes by increasing taxes and/ or by spending
less money on job creation or the mitigation of citizens' personal expenditures.

Subsidizing; Income elasticity of demand might not really be all that useful to governments,
however, because it focuses on changes in the quantity demanded for specific products, not for all
products in general. When the government lowers taxes, it probably does not care very much
about whether consumers buy more clothes or whether they buy more restaurant meals. The
government just wants consumers to buy more goods or services in general. Since income
elasticity of demand has to do with the demand for specific goods or services, it is not as useful
for the government, which is not in the business of selling specific goods or services. If the
government does sell goods or services to the people, then it will be important for it to know about
income elasticity of demand.

Formulation of Government Policies: refers to an important significance of the concept of price

elasticity of demand. The government takes into consideration the price elasticity of demand while
planning taxes. For example, tax on products having elastic demand generate less revenue for the
government as the taxes increase the price of products, which results in decrease in demand. On
the contrary, a high rate of tax is levied on products having inelastic demand. Apart from this, the
government also considers the price elasticity of demand before implementing any price control

Government Intervention in the Market: Some governments believe that some things (basic
necessities such as petrol) should be affordable to all, as income is unevenly distributed, so people
should be able to afford these basic goods at a reasonable price. As such, they may intervene in
the free market and set a maximum price that a good could be valued at ( this is known as a price
ceiling ) and a minimum price that a good could be valued at (this is known as a price floor).

Sector budgeting; Again this is examining the concept of luxury versus necessity. It is usually
luxuries that are cut if people have a decrease in their level of income and they are short of money
i.e. for any necessities that may be elastic, they may find perfect substitutes for them for less
money. The concept of 'Normal' versus 'Inferior' goods is also important when examining the
effects that a persons income may have on their demand for certain products. For instance, if a
persons income increases, their demand for certain 'lower quality' products might decrease such
as food, if their incomes are higher, they will be able to afford better quality and perhaps more
wholesome food. Likewise, if a persons income decreases, then their demand for 'normal' goods
might decrease and they may resort to buying the ' inferior' goods in order to save money.

Allocation and distribution public goods; Governments must provide "public goods" that benefit
all citizens, such as law and order and national defense. They should also be involved in providing
goods and services with large external benefits to society, such as primary education, basic health
care, and immunization programs. Direct investment or regulation is needed to control monopolies
caused by a single source of supply or large returns to scale relative to the size of the marketwater
supply, sanitation, and power, for instance.

In conclusion, the concept of income elasticity of demand is important to governments because it

allows them to calculate how much an increase or decrease in the price of a good will affect the
consumption of a public services i.e. how much they will profit. For example, an increase in the
price of an elastic good due to an increase in the tax, will affect the quantity of the good which
will be demanded by consumers. In this case it is up to them to decide whether they can justify an
increase in the tax and risk the decrease in demand for the good. An increase in the tax of an
inelastic good would increase the total revenue because there would be no real change in the
demand for the good despite the tax increase.

Dale M. Heien and Cathy Roheim Wessels, The Demand for Dairy Products: Structure,
Prediction, and Decomposition, American Journal of Agricultural Economics 70:2 (May 1988):

David Romer, Do Students Go to Class? Should They? Journal of Economic Perspectives 7:3
(Summer 1993): 167174.