Income elasticity of demand

In economics, income elasticity of demand measures the responsiveness of the

quantity demanded for a good or service to a change in the income of the people
demanding the good. It is calculated as the ratio of the percentage change in
quantity demanded to the percentage change in income.

In all, there are five types of income elasticity of demand :

High income elasticity of demand (YED>1): An increase in income is

accompanied by a proportionally larger increase in quantity demanded. This is
typical of a luxury or superior good.

Unitary income elasticity of demand (YED=1): An increase in income is

accompanied by a proportional increase in quantity demanded.

Low income elasticity of demand (YED<1): An increase in income is

accompanied by less than a proportional increase in quantity demanded. This is
characteristic of a necessary good.

Zero income elasticity of demand (YED=0): A change in income has no effect

on the quantity bought. These are called sticky goods.

Negative income elasticity of demand (YED<0): An increase in income is

accompanied by a decrease in the quantity demanded. This is an inferior good (all
other goods are normal goods). The consumer may be selecting more
luxurious substitutes as a result of the increase in income.

Normal Goods:
Normal goods have a positive income elasticity of demand so as
consumers' income rises more is demanded at each price i.e. there is an
outward shift of the demand curve
Normal necessities have an income elasticity of demand of between 0
and +1 for example, if income increases by 10% and the demand for fresh
fruit increases by 4% then the income elasticity is +0.4. Demand is rising
less than proportionately to income.
Luxury goods and services have an income elasticity of demand >
+1 i.e. demand rises more than proportionate to a change in income for
example a 8% increase in income might lead to a 10% rise in the demand
for new kitchens. The income elasticity of demand in this example is
+1.25.

Inferior Goods:
Inferior goods have a negative income elasticity of demand meaning that
demand falls as income rises. Typically inferior goods or services exist
where superior goods are available if the consumer has the money to be
able to buy it. Examples include the demand for cigarettes, low-priced own
label foods in supermarkets and the demand for council-owned properties.

Normal goods Example:

When the equation gives a positive result, the good is a normal good. A normal good
is one where demand is directly proportional to income. For example, if, following an
increase in income from 40,000 to 50,000, an individual consumer buys 40 DVD
films per year, instead of 20, then the coefficient is:
+100/+25
= (+) 4.0
The positive sign means that the good is a normal good, and because the coefficient
is greater than one, demand for the good responds more than proportionately to a

change in income. This indicates the good is not a necessity like food, and would be
considered a relative luxury for this individual.

Inferior goods Example:

When YED is negative, the good is classified as inferior. For example, if, following an
increase in income from 40,000 to 50,000, a consumer buys 180 loaves of bread
per year instead of 200, then the YED is:
-10/+25
= (-) 0.4
The negative sign means that the good is inferior, and, because the coefficient is
less than one, demand for the good does not respond significantly to a change in
income. This indicates that the good is not particularly inferior compared with a good
which has a YED of > (-)1.

Why does a firm want to know YED?

There several reasons why a firm would want to know YED, including the following:

Sales forecasting

A firm can predict the impact of a change in income on sales volume (Q), and sales
revenue (P x Q).
For example, a hypothetical car manufacturer has calculated that YED with respect
to its luxury car is (+) 3.8, and it has also undertaken research to discover that
consumer incomes will rise by 2% next year. It can now predict the impact of this
change.

Pricing policy

Knowing YED helps the firm decide whether to raise or lower price following a
change in consumer incomes. If incomes are falling and YED is positive, a reduction
in price might help compensate for the reduction in demand.

Diversification

Firms can diversify and offer a range of goods with different YEDs to spread the risks
associated with changes in the level of national income. For example, a car

manufacturer may produce cars with a range of YED values, so that sales are
stabilised as the economy grows and declines.

The higher the positive value for YED, the greater the effect of a change in
national income on consumer demand.
How do Firms make use of estimates of income elasticity of demand?
Knowledge of income elasticity of demand helps firms predict the effect of an
economic cycle on sales. Luxury products with high income elasticity see greater
sales volatility over the business cycle than necessities where demand from
consumers is less sensitive to changes in the cycle.
Income elasticity and the pattern of consumer demand
As we become better off, we can afford to increase our spending on different goods
and services. The income elasticity of demand will also affect the pattern of demand
over time.

For normal luxury goods - income elasticity of demand exceeds +1, so as

incomes rise, the proportion of a consumer's income spent on that product will
go up.

For normal necessities (income elasticity of demand is positive but less than
1) and for inferior goods (where the income elasticity of demand is negative)
then as income rises, the share or proportion of their budget on these
products will fall

For inferior goods as income rise, demand will decline and so too will the
share of income spent on inferior products.