Would you afford to buy an item you wanted if your income increased by 20% in a particular month? The answer will differ from person to person because their incomes and preferences are different, and their consumption decisions react to changes differently. Eager to learn more? Let’s talk about the income elasticity of demand.
Income elasticity of demand measures the responsiveness of the quantity demanded to a change in consumer income.
When consumer income falls, quantity demanded decreases as consumers are able to afford less due to their lower income. The reverse is also true. When consumer income rises, quantity demanded increases as consumers are able to afford more at higher income.
A fall in consumer income would shift the demand curve inwards resulting in less quantity demanded at each price level. Conversely, a rise in consumer income would shift the demand curve outwards resulting in more quantity demanded at each price level.
Figure 1 illustrates a case of an increase in consumer income on household appliances. A rise in consumer income shifts the demand curve outwards from D1 to D2. At any given price level, P, consumers will demand more household appliances (Q2 instead of Q1).
Figure 1. Increase in demand due to a rise in consumer income, StudySmarter Originals
How to calculate the income elasticity of demand?
We calculate income elasticity of demand as a percentage change in the quantity demanded divided by a percentage change in income.
The formula for the income elasticity of demand (YED) is:
This formula shows that income elasticity of demand is a unit-free measure as a percentage change is divided by another percentage change.
You can find a percentage change in a variable by using the following formula:
Roy’s monthly income rises due to a 10% salary increase. He decides to purchase some small domestic appliances and increases his spending in a particular month by 20%. His income elasticity of demand for small domestic appliances that month is then equal to:
Income elasticity of demand and normal and inferior goods
There are two types of goods depending on how their quantity demanded reacts to changes in consumer income:
• Normal goods.
• Inferior goods.
Normal and inferior goods
Most types of goods are normal goods. This means that as consumer income rises they demand more of a normal good. The income elasticity of demand for a normal good is, therefore, positive.
A normal good is a good that is demanded more as consumers’ income increases.
Most food is a normal good. As consumer income increases, the demanded quantity of food increases as well.
Inferior goods are different. As consumer income rises they demand less of an inferior good. The income elasticity of demand for an inferior good is, therefore, negative.
An inferior good is a good that is demanded less as consumers’ income increases.
Canned meats tend to be an inferior good: their price is relatively low, which makes them affordable. However, as consumer income increases, they substitute the cheaper canned meat for more expensive fresh meat. This leads to a fall in the demanded quantity of canned meat.
Luxury goods, necessities, and essentials
Normal goods can be divided into two categories depending on the value of the income elasticity of demand. Both necessities and luxuries will have a positive income elasticity of demand. The income elasticity of demand will take the values between 0 and 1 for necessities, whilst for luxuries, the income elasticity of demand will take values greater than one.
We require necessities for consumption, which makes them less sensitive to income changes.
Necessities are the goods without which people would have problems subsisting, making those goods income inelastic.
We don’t require luxuries for consumption, which makes them more sensitive to income changes.
Luxuries are the goods without which people would not have a problem subsisting, making those goods income elastic.
Essential goods are considered staple items for a consumer.
Most people may consider bread an essential daily item. In Mediterranean countries like Cyprus, olive oil would also be considered an essential good.
Values of the income elasticity of demand
The table below summarises all the values that the income elasticity of demand (YED) can take.
| Values of YED | Quantity demanded (QD) response to income (I) change | Type of demand | Type of good |
| YED <0 | QD ↓ as I ↑ QD changes by a larger proportion than a change in I. | Elastic demand with negative income elasticity. | Inferior good. |
| -1 <YED <0 | QD ↓ as I ↑ QD changes by a smaller proportion than a change in I. | Inelastic demand with negative income elasticity. | Inferior good. |
YED = -1 | QD ↓ as I ↑ QD changes proportionally with I | Unitary income elastic demand with negative income elasticity. | Inferior good. |
YED = 0 | QD stays the same as I changes | Demand with zero income elasticity. | Essential good. |
0 <YED <1 | QD ↑ as I ↑ QD changes by a smaller proportion than a change in I. | Income inelastic demand. | Normal good (necessity). |
YED = 1 | QD ↑ as I ↑ QD changes proportionally with I. | Unitary income elastic demand. | Normal good. |
YED> 1 | QD ↑ as I ↑ QD changes by a larger proportion than a change in I. | Income elastic demand. | Normal good (luxury). |
As you can see in the table above, the income elasticity of demand will always be negative for an inferior good and will always be positive for a normal good. Depending on the elasticity value, the demanded quantity will change either in the same, by a larger or by a smaller proportion as the change in income. Income elasticity of demand will be equal to 0 when there is no apparent relationship between the quantity demanded and income. So, we can’t deduce whether a good is a normal good or an inferior good.
What types of demand are there based on the income elasticity of demand?
There are three types of demand based on how much a good’s demanded quantity changes when consumer income changes.
These are:
• Unitary income elastic demand.
• Income inelastic demand.
• Income elastic demand.
Unitary income elastic demand
Demand is unitary income elastic (takes values equal to 1 or -1, or the absolute value of elasticity is equal to 1) if a change in consumer income leads to a proportionate change in the demanded quantity.
Isabella’s disposable income rises from £200 to £300 due to a wage bonus (that is an increase of 50%). She decides to go to the hairdresser more often so she increases her salon spending from £60 to £90 (that is an increase of 50%). Her income elasticity of demand for the hairdresser services is then equal to 50%/50% = 1 in absolute value, which means that her spending rises in the same proportion as her income.
Income inelastic demand
Demand is income inelastic (takes values between -1 and 1, or the elasticity is less than 1 in absolute value) if a change in consumer income leads to a less than proportionate change in the demanded quantity.
Wayne loves going to a restaurant to eat sushi. He usually goes to his favorite restaurant to eat sushi three times a week. Imagine his income decreased by 20%. His demand would also decrease but by only 2% compared to a fall in his income. Calculation: -2% / - 20% = 0.1 (less than 1 in absolute value). Wayne would still go to his favorite restaurant to eat sushi three times a week despite a fall in his income because his demand for sushi is income inelastic.
The example above illustrates that despite a typical inelastic demand response for essential items, personal preferences also play a role in the value that the income elasticity of demand takes.
Income elastic demand
Demand is income elastic (takes values <-1 and> 1, or the elasticity is greater than 1 in absolute value) if a change in consumer income leads to a more than proportionate change in the quantity demanded.
Rosie is a Star Wars fan and collects Funko Pop toys of her favorite characters. She received £100 extra income on her birthday to an additional £20 she already had (this is an increase of 500%). She decides to spend it all on the toys (that is an increase in the quantity demanded of 100%). Her income elasticity of demand is: 500%/100% = 5. Her income elasticity of demand is greater than one in absolute value, therefore her demand is income elastic.
What factors affect the income elasticity of demand?
Some of the most prominent factors that affect income elasticity of demand are market definition, time horizon, availability of substitutes, and luxuries vs necessities. You should consider these when thinking of the examples and application of income elasticity of demand.
Market definition
The income elasticity of demand depends on how broadly we define the market for a product. The broader the market definition, the less income elastic demand would be. In contrast, the narrower the market definition, the more income elastic demand would be.
If you define the market as ‘food’, demand for it would be income inelastic as we depend on food for daily subsistence. However, if you define the market for ‘rye flour’, then demand for it will be relatively more income elastic as there are other flour types that a household can consume.
Time horizon
In general, demand tends to be more income elastic the longer the time horizon that defines a market. This is mainly due to supply-side factors such as technological changes, economies of scale, and production capacity.
In the short run, demand is relatively income inelastic. But in the long run, it becomes more elastic as there is more time for the supply-side changes to come into effect and for consumers to react.
Even if your income rises substantially in the short run, you may not be able to buy the newest iPhone before its release date. Thus, your iPhone demand will be income inelastic in the short run. However, as the production and distribution unfold, you will be able to buy it more easily, making your demand relatively more income elastic in that period.
The example above demonstrates how the time horizon would affect demand in a way that makes it relatively more income elastic. Even though for a large proportion of people an iPhone will still be a luxury (demand will already be quite income elastic), their demand will be relatively less income elastic than in the short run when the iPhone is simply unavailable due to production and distribution lags.
Availability of substitutes
The availability of substitutes determines how income elastic or inelastic demand for a good is. Demand for a good with a lot of substitutes that are deemed appropriate by consumers will tend to be more income elastic than the demand for a good with fewer or no substitutes. That is because consumers can switch from one good to another more easily when there are more substitutes available.
There are a lot of competitorsIn the market for music streaming services. If your income falls, you can easily switch from an Apple Music subscription to a Spotify subscription, which is cheaper. Your demand for music streaming services is therefore relatively income elastic.
Luxury goods vs necessities
Demand for luxury goods tends to be more income elastic than for necessities. This is because necessities are required for subsistence and their absence can cause significantly lower consumer utility. Luxuries, however, are goods on which subsistence does not depend, and therefore more income elastic.
Utility is the satisfaction that a person obtains from consuming a good or a service
If your income falls, you will be more likely to reduce your expenditure on precious metal jewellery than on food. This is because your demand for jewellery is more income elastic than your demand for food. Jewellery is a luxury whereas food is a necessity.
Income elasticity of demand is a useful measure that allows us to see how the consumer quantity demanded will respond to income changes. Income elasticity of demand is important for businesses as it can give business owners insights of how much consumer demand will change in case of a crisis or high inflation when real consumer income falls.
Income elasticity of demand - Key takeaways
- Income elasticity of demand is a measure of the responsiveness of the quantity demanded to a change in consumer income.
- Income elasticity of demand is calculated as a percentage change in the quantity demanded divided by a percentage change in income.
- A normal good is demanded more as consumers’ income increases. The income elasticity of demand for a normal good is therefore positive.
- An inferior good is demanded less as consumers’ income increases. The income elasticity of demand for an inferior good is therefore negative.
- Demand is unitary income elastic if a change in consumer income leads to a proportionate change in the quantity demanded.
- Demand is income inelastic if a change in consumer income leads to a less than proportionate change in the quantity demanded.
- Demand is income elastic if a change in consumer income leads to a more than proportionate change in the quantity demanded.
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