BE/U2 Topic 3 Income Elasticity of Demand
The elasticity of demand measures how factors such as price and income affect the demand for a product. The income elasticity of demand measures how the change in a consumer’s income affects the demand for a specific product. You can express the income elasticity of demand mathematically as follows:
Income Elasticity of Demand (YED) = % change in quantity demanded / % change in income
The higher the income elasticity of demand for a specific product, the more responsive it becomes the change in consumers’ income.
Now, we can measure the income elasticity of demand for different products by categorizing them as inferior goods and normal goods. The income elasticity of demand for a particular product can be negative or positive, or even unresponsive.
Normal Goods and Luxuries
The income elasticity of demand for a product can elastic or inelastic based on its category—whether it is an inferior good or a normal good. Now, the coefficient for measuring income elasticity is YED.
When YED is more than zero, the product is income-elastic. Normal goods have positive YED. That is, when the consumers’ income increases, the demand for these goods also increases.
However, normal goods can further be broken down into normal necessities and normal luxuries. Normal necessities have a positive but low income-elasticity compared to luxurious goods.
The income elasticity coefficient or YED for normal necessities is between 0 and 1. Normal necessities include basic needs such as milk, fuel, or medicines.
Factors such as a change in price or change in consumers’ income do not affect the demand for necessary goods. The percentage of change in the demand for these products is less in proportion to the percentage of change in consumers’ income.
Luxuries, on the other hand, are highly income-elastic. Examples of luxury goods include high-end electronics or jewellery. For instance, if a consumer’s income increases, he/she may invest or purchase a high-end mobile or an HD television.
The percentage of change in demand is more in proportion to the change in income. However, it is important to note that the concept of luxury is contextual and it depends on the circumstances of consumers.
Inferior goods have a negative income elasticity; that is YED is less than 0. If the consumers’ income increases, they demand less of these goods. Inferior goods are called inferior because they usually have superior alternatives.
For instance, if a consumer’s income increases, then he/she might start taking a cab instead of opting for public transport. Public transport, in this case, is an inferior good.
Usually, when the economic growth is good and there is an increase in consumers’ income, the demand for inferior goods reduces and there is an inward swing of the demand curve.
Consequently, when the incomes reduce and price of goods increases because of recession, then the demand for inferior goods increases, thereby causing an outward swing of the demand curve.