Why Price Elasticity and Income Elasticity of Demand Differ Across Products

Question

All brands of smartphones are available in different models. Global economic recovery and the rise in cost of key smartphone components are likely to have affected the sales of various models of smartphones in different ways.

(a) Explain what might cause price elasticity of demand and income elasticity of demand to be different for different products. [10]

Answer

The value of a product’s price elasticity of demand reflects the responsiveness of quantity demanded to a change in its own price, while its income elasticity of demand reflects the responsiveness of demand to a change in income. The two differ across products for distinct reasons: $PED$ varies with the determinants of own-price responsiveness, while $YED$ varies with the nature of the good — whether it is normal or inferior, necessity or luxury.

Why PED differs across products. Four determinants — availability of substitutes, degree of necessity, proportion of income spent, and time period — set a good’s $PED$, as catalogued under applying PED. The most important is the availability of close substitutes: where strong substitutes exist, demand is price elastic ($|PED| > 1$), because a price rise sends consumers readily to alternatives. A particular smartphone model or brand has many close substitutes, so its demand is elastic — a price rise causes a more than proportionate fall in quantity demanded as buyers switch to rival models. Degree of necessity works the other way: a basic-function model deemed a necessity, or conversely a premium latest model with unique features (speed, design) and few close substitutes, has price inelastic demand ($0 < |PED| < 1$), so a price rise causes a less than proportionate fall in quantity demanded. The proportion of income a good absorbs and the time period allowed for adjustment reinforce these: goods taking a large income share, and longer time horizons, both raise $PED$.

Why YED differs across products. $YED$ differs according to the type of good. Goods with $YED > 0$ are normal goods, whose demand moves with income; goods with $YED < 0$ are inferior goods, whose demand moves against income. Within normal goods, necessities are income-inelastic ($0 < YED < 1$) — a basic-function phone bought to sustain daily communication sees only a small demand rise as income grows — whereas luxuries are income-elastic ($YED > 1$): as consumers grow affluent they buy newer, more capable models, so demand rises more than proportionately, much as buyers in fast-growing economies switch from bicycles to cars or queue for the newest iPhone. Inferior goods illustrate the negative case: an old handphone model (relative to newer ones) has $YED < 0$, since rising income leads consumers to abandon it for a normal good.

In sum, $PED$ differs across products because of the determinants of own-price responsiveness — chiefly the availability of substitutes, but also necessity, income share and time — while $YED$ differs because of the product’s nature as a necessity, luxury or inferior good. The same item can sit at very different points on both scales depending on the model and the consumer’s income, which is why different smartphone models behave so differently.