Unlocking the Power of Income Elasticity of Demand
Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain good to a change in the real income of consumers who buy this good.
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.
Key Takeaways
- Income Elasticity of Demand is an economic measure of how responsive the quantity demanded for a good or service is to a change in income.
- The formula for calculating income elasticity of demand is the percentage change in quantity demanded divided by the percentage change in income.
- Businesses use this measure to help predict the impact of a business cycle on sales.
Understanding Income Elasticity of Demand
Income elasticity of demand measures the responsiveness of demand for a particular good to changes in consumer income.
The higher the income elasticity of demand for a particular good, the more demand for that good is tied to fluctuations in consumers’ income. Businesses typically evaluate the income elasticity of demand for their products to help predict the impact of a business cycle on product sales.
Inferior Goods vs. Normal Goods
Depending on the values of the income elasticity of demand, goods can be broadly categorized as inferior and normal goods. Normal goods have a positive income elasticity of demand—meaning as incomes rise, more goods are demanded at each price level.
Normal goods whose income elasticity of demand is between zero and one are typically referred to as necessity goods, which are products and services that consumers will buy regardless of changes in their income levels. Examples of necessity goods and services include tobacco products, haircuts, water, and electricity.
As income rises, the proportion of total consumer expenditures on necessity goods typically declines. Inferior goods have a negative income elasticity of demand; as consumers’ money rises, they buy fewer inferior goods. A typical example of such a type of product is margarine, which is much cheaper than butter.
Furthermore, luxury goods are a type of normal good associated with income elasticities of demand greater than one. Consumers will buy proportionately more of a particular good compared to a percentage change in their income. Consumer discretionary products such as premium cars, boats, and jewelry represent luxury products that tend to be very sensitive to changes in consumer income. When a business cycle turns downward, demand for consumer discretionary goods tends to drop as workers become unemployed.
Formula for Income Elasticity of Demand
The formula for income elasticity of demand is:
Income Elasticity of Demand = \frac{ \frac {D_1 - D_0}{D_1 + D_0} }{ \frac {I_1 - I_0}{I_1 + I_0} }
where:
D_0 = Initial quantity demanded
D_1 = Final quantity demanded
I_0 = Initial real income
I_1 = Final real income
Example of Income Elasticity of Demand
Consider a local car dealership that gathers data on changes in demand and consumer income for its cars for a particular year. When the average real income of its customers falls from $50,000 to $40,000, the demand for its cars plummets from 10,000 to 5,000 units sold, all other things unchanged.
The income elasticity of demand is calculated by taking a negative 50% change in demand and dividing it by a 20% change in real income. This produces an elasticity of 2.5, which indicates local customers are particularly sensitive to changes in their income when it comes to buying cars.
Types of Income Elasticity of Demand
There are five types of income elasticity of demand:
- High: A rise in income comes with bigger increases in the quantity demanded.
- Unitary: The rise in income is proportionate to the increase in the quantity demanded.
- Low: A jump in income is less than proportionate to the increase in the quantity demanded.
- Zero: The quantity bought/demanded is the same even if income changes.
- Negative: An increase in income comes with a decrease in the quantity demanded.
Interpreting Income Elasticity of Demand
Income elasticity of demand describes the sensitivity to changes in consumer income relative to the amount of a good that consumers demand. Highly elastic goods will see their quantity demanded change rapidly with income changes, while inelastic goods will see the same quantity demanded even as income changes.
Practical Insights: What Does an Income Elasticity of Demand of 1.50 Mean?
Since the value is positive, the good is elastic. It implies that for every 1% increase in income, people will demand an increase of 1.5% in the number of goods. Thus, if the average income is $100,000, and at that level of income, people desire 70 meals out a year, they would demand 71 meals a year if income rose to $101,000 (1.5% of 70 = 1.05 meals more).
Income vs. Price Elasticity: What Sets Them Apart?
Price elasticity of demand measures the change in the percentage of demand caused by a percent change in price rather than a percent change in income.
Can Income Elasticity of Demand Be Negative?
Yes, for example, with certain “inferior” goods, the more money people have, the less likely they are to buy cheaper products in favor of higher-quality ones.
Examples of Inelastic Goods
Inelastic goods tend to have the same demand regardless of income. Certain staples and basics such as gasoline or milk would not change with income—you’ll still only need one gallon a week even if your income doubles.
The Bottom Line
Income elasticity of demand is the change in quantity demanded of a good or service about the change in the real income of a consumer that buys that good or service. It denotes whether a product is an essential item or a luxury item.
The higher the inelasticity of demand for a good or service, the more sensitive the demand for it is to fluctuations in consumer income. If a good or service has high inelasticity of demand, it will experience a decline in demand when the real income of consumers decreases. If real income increases, it will see an increase in demand. If a good or service has low inelasticity of demand, its demand will not significantly change regardless of what happens to the real income of consumers.
Related Terms: Price Elasticity of Demand, Necessity Goods, Luxury Goods, Inferior Goods.
