Applications of YED

The value of the income elasticity of different goods and services has different implications for
different producers and for different industries, depending on the stage of growth that an economy is
going through.

Implications of YED for firms

To start with, knowing the income elasticity of the goods that you sell, allows the firm to estimate
what will happen to its sales and revenues in different economic scenarios.
Over time, economies experience periods of positive economic growth and negative economic
growth, when society's income increases or decreases correspondingly. Increasing income means a
growing demand for goods and services, while the other scenario means the opposite.
If you are an inferior good producer, and it is expecting a slowing down of the economy, a fall in
employment and therefore a fall in people's income, then, depending on how income elastic the
demand of your good is, the extent of the increase is expected in the sales of your product.
If you sell normal or superior goods, then it would also be important to know the extent of the fall of
the demand of your goods, as people have less money to spend in a recessionary scenario.

Definition
Recession is a persistent fall in real GDP in an economy, where unemployment tends to increase.
Two consecutive quarters of negative GDP growth is considered a recession.

Be Aware
In periods of economic recession, goods and services with the highest YED (YED>1), will be the
ones whose market will suffer the largest fall. While products with low YED (YED<1), may avoid a
large reduction in sales, and inferior goods (YED<0) can even experience an increase.
In a growing economy, producers of inferior goods will expect a fall in their sales, while normal and
superior good producers will expect the contrary.

As we've seen in previous sections, the higher the YED, the more sensitive the demand of the good
or service to changes in people's income. If goods have an income elastic demand (YED>1), this
means that the quantity demanded of these goods will increase more than proportional to the
increase in income. Goods and services that have high YED tend to be superior goods, luxury goods
and services, such as restaurants, health care, and foreign travel.
If goods have income inelastic demand (YED< 1), this means that the quantity demanded of these
goods will increase less than proportional to the increase in income. Goods and services that
have low YED tend to be necessities, such as food and clothing.

Definition
Economic growth is defined as positive GDP growth in a specific time period. It usually implies a
growth in employment in the economy, and therefore in people's income.

Be Aware
In periods of economic growth, goods and services with highest YED (YED>1), will be the ones
whose market will have the largest potential growth. While products with low YED (YED<1), may see
a small increase in sales, and inferior goods (YED<0) will probably experience a market contraction.

YED and industry growth

From what has been explained above, we can explain what happens to different industries, and their
relative shares in the total output of an economy, as the economy of a country goes through different
stages of growth.
Industries in an economy are divided into three sectors:

The primary sector, which includes all primary commodities and products (agriculture,
forestry, fishing and extractive industries).

The manufacturing sector, which includes all of those industries producing elaborated
goods from primary products or other manufactured intermediate goods (clothes, machines,
cars, houses, books, paper, wine, etc.).

The services sector, which includes all economic goods which are not tangible and yet
improve the quality of life or standards of living of people (entertainment, travel, insurance,
banking, healthcare, education, etc.).

As an economy grows through time, the relative size of these sectors, as a percentage of total output
in the economy, varies. This has to do with their value of YED. Figure 1 shows an example of a
hypothetical economy.

Figure
1. Changes in composition of a country's output per sector
at different growth stages.

We already know that necessary goods like food have an income inelastic demand, therefore, as the
economy grows and achieves higher levels of National Income, the demand for food and other
primary goods as agriculture will increase less in relative terms than any increase in national income.
On the other hand, as an economy has a higher level of National Income, people will tend to
consume more manufactured goods which have a higher YED than primary goods, and more
services, which have an even higher YED than manufactured.
When an economy achieves a high level of economy growth, its primary sector, in relation to the
other two sectors, is very small, and most of the economy's output and consumption has to do with
services.
This evolution is what Figure 1 shows. Over time, the share of agricultural output in total output in
the economy decreases, while the share of manufactured output grows. As the economy continues
growing, the services sector expands relatively to the other two.

Important
Economically less developed countries usually have a large primary sector, while manufacturing and
services are less important. With economic growth, primary sector becomes less important, and it is
greatly replaced by manufacturing and services. As the economy grows further, this process
continues and manufacturing becomes increasingly replaced by services.

Be Aware
Note that if total output increases over time, the fact that the proportion of primary sector is falling,
does not necessarily mean that the primary sector's output is falling. It just means that this sector's
output is increasing, but at a lower rate than the rest of the economy.