Question

‘Prompted by the recession in Europe to search for promising wealthy new markets, the German Luxury Goods Exhibition in Dubai attracted top German designer names supplying perfumes, silverware, crystal and jewellery. The response to the exhibition was extremely positive.’ (Gulf News, 3 November 2016) Explain the Terms (i) Income elasticity of demand (ii) cross-elasticity of demand. How can these terms be applied to the market for German luxury goods, and (given that Dubai is a rich Middle Eastern Estate) how might they be used to explain the success of the exhibition? What are economies of scale and why are such economies available only in the long run? Since economies of scale exist, why do long-run marginal costs increase, ultimately, as output increases?

Answer 1

1. Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain good to a change in real income of consumers who buy this good, keeping all other things constant. The formula for calculating income elasticity of demand is the percent change in quantity demanded divided by the percent change in income. With income elasticity of demand, you can tell if a particular good represents a necessity or a luxury.

Types of Income Elasticity of Demand

There are five types of income elasticity of demand:

1. High: A rise in income comes with bigger increases in the quantity demanded.
2. Unitary: The rise in income is proportionate to the increase in the quantity demanded.
3. Low: A jump in income is less than proportionate than the increase in the quantity demanded.
4. Zero: The quantity bought/demanded is the same even if income changes
5. Negative: An increase in income comes with a decrease in the quantity demanded.

2. The cross elasticity of demand is an economic concept that measures the responsiveness in the quantity demanded of one good when the price for another good changes. Also called cross-price elasticity of demand, this measurement is calculated by taking the percentage change in the quantity demanded of one good and dividing it by the percentage change in the price of the other good.

Given that the Dubai is the rich country the quantity demanded will be more and the willingness of the consumer base who are ready to spend on these luxury items will also be more and hence the success of the exhibition.

Economies of scale are the cost advantages that enterprises obtain due to their scale of operation, with cost per unit of output decreasing with increasing scale. Economies of scale are available only in the long run because the fixed capital expenditure could be appropriated to more number of years and the production.

Example

Long Run

A business with a one-year lease will have its long run defined as any period longer than a year since it’s not bound by the lease agreement after that year. In the long run, the amount of labor, size of the factory, and production processes can be altered if need be to suit the needs of the business or lease issuer.

Marginal cost is the change in the total cost that arises when the quantity produced is incremented by one unit; that is, it is the cost of producing one more unit of a good. Hence it is product specific and with increase in number of good the marginal will go up accordingly.