(2024) A Level H2 Econs Paper 2 Essay Q3a

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Introduction

The income elasticity of demand (YED) measures the responsiveness of the demand for a good to a change in consumer income, ceteris paribus. It is calculated as the percentage change in quantity demanded divided by the percentage change in income. When a government reduces the rate of income tax, the disposable income of consumers increases, providing them with greater purchasing power. The extent to which this increase in disposable income impacts expenditure depends on the YED of the goods in question.

If YED is positive but less than 1

When the YED of a good is positive but less than 1, the good is classified as a necessity. For such goods, an increase in income results in an increase in demand, but less than proportionately. This means that while expenditure on these goods rises as income increases, the increase is relatively small.

An example of a necessity is groceries. Even if consumers experience a rise in disposable income, their demand for basic food items such as bread or rice will only increase slightly, as there is a natural limit to how much more they can consume. For instance, a family earning an additional $500 per month might spend a small portion of this extra income on higher-quality groceries but would not substantially increase the quantity of food purchased. Thus, the overall increase in expenditure on such goods is modest.

If YED is positive but more than 1

When the YED of a good is positive and greater than 1, the good is classified as a luxury. For such goods, an increase in income leads to a more than proportionate increase in demand. This means that expenditure on these goods rises significantly when disposable incomes increase.

An example of a luxury good is a luxury cruise vacation, such as a Disney Cruise. Higher-income consumers are more likely to allocate their additional disposable income towards discretionary spending on high-end experiences or items. For example, a household experiencing a significant tax cut may decide to book a cruise or purchase designer goods, as these are not necessary for everyday living but represent aspirational spending. Consequently, the expenditure on such goods tends to rise sharply with an increase in income.

If YED is negative

When the YED of a good is negative, the good is classified as an inferior good. For these goods, an increase in income results in a decrease in demand. This means that expenditure on these goods declines as disposable income rises.

An example of an inferior good is close-to-expiry food sold at dollar stores. As consumers experience an increase in disposable income, they are likely to substitute inferior goods with higher-quality alternatives. For instance, a family that previously relied on heavily discounted food items may opt to purchase fresher or branded products from higher-end supermarkets. Thus, expenditure on inferior goods declines as consumers' purchasing power increases.

Conclusion

The impact of a reduction in the rate of income tax on expenditure depends heavily on the income elasticity of demand for different goods. Necessities, with a YED between 0 and 1, see a modest rise in expenditure, while luxuries, with a YED greater than 1, experience a significant increase in spending. In contrast, inferior goods, with a negative YED, witness a decline in expenditure as consumers shift towards higher-quality alternatives.

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