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MB0042 – Q.1 Income elasticity of demand has various applications. Explain each application with the help of an example.

Answer:
Income elasticity of demand may be defined as the ratio or proportionate change in the quantity demanded of a commodity to a given proportionate change in the income. In short, it indicates the extent to which demand changes with a variation in consumer’s income. The following formula helps to measure Ey.

Original demand = 400 units Original Income = 4000-00
New demand = 700 units New Income = 6000-00


Generally speaking, Ey is positive. This is because there is a direct relationship between income and demand, i.e. higher the income; higher would be the demand and vice-versa. On the basis of the numerical value of the co-efficient, Ey is classified as greater than one, less than one, equal to one, equal to zero, and negative. The concept of Ey helps us in classifying commodities into different categories.

1. When Ey is positive, the commodity is normal [used in day-to-day life]
2. When Ey is negative, the commodity is inferior. For example Jowar, beedi etc.
3. When Ey is positive and greater than one, the commodity is luxury.
4. When Ey is positive, but less than one, the commodity is essential.
5. When Ey is zero, the commodity is neutral e.g. salt, match box etc.

Practical application of income elasticity of demand
1. Helps in determining the rate of growth of the firm.
If the growth rate of the economy and income growth of the people is reasonably forecasted, in that case it is possible to predict expected increase in the sales of a firm and vice-versa.

2. Helps in the demand forecasting of a firm.
It can be used in estimating future demand provided the rate of increase in income and Ey for the products are known. Thus, it helps in demand forecasting activities of a firm.

3. Helps in production planning and marketing
The knowledge of Ey is essential for production planning, formulating marketing strategy, deciding advertising expenditure and nature of distribution channel etc in the long run.

4. Helps in ensuring stability in production
Proper estimation of different degrees of income elasticity of demand for different types of products helps in avoiding over-production or under production of a firm. One should also know whether rise or fall in income is permanent or temporary.

5. Helps in estimating construction of houses
The rate of growth in incomes of the people also helps in housing programs in a country. Thus, it helps a lot in managerial decisions of a firm.

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