Income Elasticity of Demand

What Is 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.

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 consumer's income. For example, businesses typically evaluate the income elasticity of demand for their products to help predict the impact of a business cycle on product sales.

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; 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' income 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.

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, a drop of 5,000 divided by the initial demand of 10,000 cars, and dividing it by a 20% change in real income — the $10,000 change in income divided by the initial value of $50,000. 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:

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 to 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. 

How Do You Interpret 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.

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 1.5x the number of goods. Thus, if the average income is $100,000 and at that level of income people desire 6 meals out per week, they would demand 9 meals out if income rose to $101,000.

How Does Income Elasticity of Demand Differ from Price Elasticity of Demand?

Price elasticity of demand measures the change in 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.

What Is Something That Is Inelastic to Changes in Income?

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.