Reviewed by Sep 30, 2020| Updated on
Income elasticity of demand refers to the sensitivity ratio between the quantity of a specific product and the change in the real income of consumers who buy this product, keeping other things constant.
The formula for measuring income elasticity of demand is the percentage increase in demand quantity divided by the rise in sales rate. With income elasticity of demand, one can say whether a particular product represents an essential requirement or a luxury.
Income elasticity of demand tests the sensitivity of demand to shift in consumer price for a specific product. The higher the income elasticity of demand given in absolute terms for a particular product, the higher will be the reaction of customers in their purchasing habits if their real income shifts. Businesses usually evaluate income elasticity of demand for their products to help them predict the impact of a business cycle on product sales.
Goods may be loosely classified as inferior goods and normal goods, depending on the values of the income elasticity of demand. Normal goods have a positive demand elasticity of income; as sales increase, more products are demanded.
Normal goods whose income elasticity of demand value is between zero and one are often referred to as necessary goods. Customers will buy them irrespective of changes in their value rates. Examples of such goods and services include tobacco products, haircuts, water, and electricity.
When income rises, the proportion of overall consumer expenditure on essential products usually decreases. Inferior goods tend to have a negative income elasticity of demand since income increases for consumers; they purchase lesser products. Vegetable oil is a common example of this type of food and is much cheaper than butter.
Luxury goods reflect goods that are associated with a higher income elasticity of demand. With a percentage rise in their wages, customers would proportionally buy more of a specific product. Market discretionary goods, such as expensive vehicles, vessels, and jewellery, are luxury items that appear to be highly responsive to market income adjustments.
Negative income elasticity of demand is related to inferior products. In other words, increasing incomes can lead to a drop in demand, and luxury goods will change. Positive income elasticity of demand is commonly associated with normal products. In this scenario, an increase in earnings would lead to a rise in demand.
Consider a local car dealer that gathers data for a given year regarding shifts in demand and customer income for their vehicles. As its consumers' average real income declines from 50,000 USD to 40,000 USD, demand for their vehicles plunge from 10,000 to 5,000 sales units, all other things unchanged.
The income elasticity of demand is calculated by taking a negative 50 per cent demand difference, a 5,000 decrease from the initial demand of 10,000 vehicles, and dividing it by a 20 per cent actual income decrease — the 10,000 USD income change divided by the initial value of 50,000 USD. It results in the elasticity of 2.5, suggesting that local consumers are especially prone to changes in their income when they buy cars.