Loading the player...

What is the 'Income Elasticity Of Demand'

Income elasticity of demand refers to the sensitivity of the quantity demanded for a certain good to a change in real income of consumers who buy this good, keeping all other things constant. 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.

BREAKING DOWN '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 in absolute terms for a particular good, the bigger consumers' response in their purchasing habits, if their real income changes. Businesses typically evaluate income elasticity of demand for their products to help predict the impact of a business cycle on product sales.

Calculation 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 fell from $50,000 to $40,000, the demand for its cars plummeted 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.

Interpretation of Income Elasticity of Demand

Depending on the values of the income elasticity of demand, goods can be broadly categorized as inferior goods 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 less of inferior goods. A typical example of such type of product is margarine, which is much cheaper than butter.

Luxury goods represent normal goods 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.

RELATED TERMS
  1. Demand Elasticity

    In economics, the demand elasticity refers to how sensitive the ...
  2. Price Elasticity Of Demand

    A measure of the relationship between a change in the quantity ...
  3. Elastic

    An economic term referring to the change in behavior that buyers ...
  4. Elasticity

    A measure of a variable's sensitivity to a change in another ...
  5. Normal Good

    An economic term used to describe the quantity demanded for a ...
  6. Cross Elasticity Of Demand

    An economic concept that measures the responsiveness in the quantity ...
Related Articles
  1. Insights

    Calculating Income Elasticity of Demand

    Income elasticity of demand is a measure of how consumer demand changes when income changes.
  2. Insights

    How Demand Changes With a Variation in Price

    What is demand elasticity?
  3. Insights

    What Is Elasticity?

    Elasticity measures the relationship between a good and its price based on consumer demand, consumer income, and its available supply. Learn the basics about it here.
  4. Insights

    What's Demand Elasticity?

    Demand elasticity is the measure of how demand changes as other factors change. Demand elasticity is often referred to as price elasticity of demand because price is most often the factor used ...
  5. Investing

    Calculating Cross Elasticity of Demand

    Cross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
  6. Investing

    Price Elasticity Of Demand

    Price elasticity of demand describes how changes in the cost of a product or service affect a company's revenue.
  7. Insights

    What Does Inferior Good Mean?

    The term “inferior good” does not describe a lack of quality, but rather, is an economic term used when discussing elasticity of demand for a good.
  8. Insights

    Why We Splurge When Times Are Good

    The concept of elasticity of demand is part of every purchase you make. Find out how it works.
  9. Insights

    What is a Normal Good?

    A normal good is any good or service that sees an increase in demand due to an increase in income.
RELATED FAQS
  1. What are some examples of demand elasticity other than price elasticity of demand?

    Learn about income elasticity of demand and cross elasticity of demand and how to interpret these two measures of demand ... Read Answer >>
  2. Which factors are more important in determining the demand elasticity of a good or ...

    Learn about demand elasticity of goods and services and the main factors that influence the elasticity of demand. Read Answer >>
  3. What types of consumer goods demonstrate the price elasticity of demand?

    Learn how the price elasticity of demand is more sensitive for some types of consumer goods than others, and see what factors ... Read Answer >>
  4. Under what circumstances might price elasticity significantly change?

    Discover under what circumstances price elasticity of demand might change and why it is such an important economic concept ... Read Answer >>
  5. How many years can structural unemployment last?

    Understand the two different types of price elasticities, and learn how each one affects the stock purchasing decision of ... Read Answer >>
  6. How does price elasticity change in relation to supply and demand?

    Learn about how variations in price elasticity affect the supply and demand curves and what factors cause differences in ... Read Answer >>
Hot Definitions
  1. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  2. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  3. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  4. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  5. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
  6. Yuppie

    Yuppie is a slang term denoting the market segment of young urban professionals. A yuppie is often characterized by youth, ...
Trading Center