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IAI Actuarial Core Principles · Business Economics · Impact of the macroeconomic environment on business

A retailer faces income elasticity of demand of +1.5 for its products. Economists forecast that real household incomes will fall by 4% while the retailer's prices stay unchanged. Ignoring other factors, what is the expected change in quantity demanded?

Demand is expected to fall by 6%. Income elasticity of 1.5 multiplied by a 4% fall in real income gives a 6% fall in quantity demanded. The product is a luxury-like good whose demand reacts more than proportionately to income.

  1. AA rise of 6%
  2. BA rise of 2.67%
  3. CA fall of 2.67%
  4. DA fall of 6%Correct
  5. A fall of 4%

Explanation

Income elasticity = % change in quantity / % change in income. So % change in quantity = 1.5 x (-4%) = -6%. Dividing 4 by 1.5 gives 2.67, which inverts the formula. A fall of 4% would assume elasticity of 1, and a rise would have the wrong sign.

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