Saturday, December 27, 2008

Theo Fennell & Income Elasticity of Demand

In the recent (23rd December), Theo Fennell, the British prime jeweller had reported its first ever loss in 3 years amounting up to £ 840,000. Its sales dropped by 20% for the period of six months to 30th September

Why is it so?

Before going into that question, I would like to introduce the economic tool of analysis called income elasticity of demand (YED)

Definition: YED measures the responsiveness of quantity demanded due to the change in income

The formula is given by, YED = (% change in quantity demanded) / (% change in income)

Application of YED

While PED (price elasticity of demand) is used to determine how sensitive certain goods towards price changes, XED (cross elasticity of demand) to determine relationships of 2 goods (whether it’s substitute or complements), YED is meant to identify the types of goods or services

(1) YED less than 0

We normally refer them to crush grain, Tesco brand bread, instant noodle etc. Here inferior goods are something that we consume lesser when our income increases. This explains why the outcome of calculation can be negative since (-% demand) / (+% income). Of course, it works vice versa. In period of difficulty or running a tight budget, our consumption on these inferior goods will increase. So (+% demand) / (-% income)

(2) YED, more than 0 less than 1

Necessities are normally clothes, toothbrush, newspaper etc. Here demand will rise along with income but less than proportionate. Therefore it yields a positive figure which is less than 1. For instance, (demand + by 30%) / (income + by 60%) = 0.5. Of course it works the other way round

(3) YED greater than 1 (luxury goods)

We often refer luxuries to things like international holidays, jewelleries, designer clothes etc. In the period of economic slowdown like now, normally businesses selling these items will be the first hit. Households would be more concern with their savings & family balance sheet. Here demand will fall along with income but greater than proportionate. Say, (demand -60%) / (income -50%) = 1.2 (positive figure). Of course it works the other way round

Back to our analysis, here Theo Fennell is in jewellery business. As such what they sell is classified as luxury goods. No wonder, their sales dropped significantly