Income elasticity of demand

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In economics, income elasticity of demand measures the responsiveness of the demand for a
good to a change in the income of the people demanding the good. It is calculated as the ratio of
the percentage change in demand to the percentage change in income. For example, if, in
response to a 10% increase in income, the demand for a good increased by 20%, the income
elasticity of demand would be 20%/10% = 2.

Interpretation

Inferior goods' demand falls as consumer income increases.

 A negative income elasticity of demand is associated with inferior goods; an increase in

income will lead to a fall in the demand and may lead to changes to more luxurious
substitutes.
 A positive income elasticity of demand is associated with normal goods; an increase in
income will lead to a rise in demand. If income elasticity of demand of a commodity is
less than 1, it is a necessity good. If the elasticity of demand is greater than 1, it is a
luxury good or a superior good.
 A zero income elasticity (or inelastic) demand occurs when an increase in income is not
associated with a change in the demand of a good. These would be sticky goods.

Income elasticity of demand can be used as an indicator of industry health, future consumption
patterns and as a guide to firms investment decisions. For example, the "selected income
elasticities" below suggest that an increasing portion of consumer's budgets will be devoted to
purchasing automobiles and restaurant meals and a smaller share to tobacco and margarine.[1]

Mathematical definition
More formally, the income elasticity of demand, , for a given Marshallian demand function
for a good is

or alternatively:

This can be rewritten in the form:

With income I, and vector of prices . Many necessities have an income elasticity of demand
between zero and one: expenditure on these goods may increase with income, but not as fast as
income does, so the proportion of expenditure on these goods falls as income rises. This
observation for food is known as Engel's law.

Income Elasticity Of Demand

What Does Income Elasticity Of Demand Mean?

A measure of the relationship between a change in income and a change in quantity of a good
demanded:
Investopedia explains Income Elasticity Of Demand
The degree to which a demand for a good changes with respect to a change in income depends on
whether the good is a necessity or a luxury. The demand for necessities will increase with income, but at
a slower rate. This is because consumers, instead of buying more of only the necessity, will want to use
their increased income to buy more of a luxury. During a period of increasing income, demand for luxury
products tends to increase at a higher rate than the demand for necessities.

Elasticity

Elasticity refers to the responsiveness of demand or supply to changes in price or income. The usual
meaning is the price elasticity of demand, or the responsiveness of the quantity demanded to price. We
speak of an elastic demand -- one which is very responsive to price, and which would result in a
relatively flat demand curve; and of an inelastic demand -- one not very responsive to price.

The language is a bit awkward. When we say inelastic, we mean the responsiveness is small not
non-existent. The terminology perfectly inelastic is sometimes used for a demand which is not
at all responsive to price.

The coefficient of elasticity or COE for short is the measure of elasticity.

It is defined as the percentage change in the quantity demanded divided by the percentage
change in price.

There are two things to note about this definition.

1. It is in terms of percentage changes, not just "changes". An increase of a dollar is a big

percentage change for a newspaper, and will lose them many customers; a dollar increase in the
price of a car will not lose many buyers -- yet the newspaper and car demand curves could have
the same elasticity. Percentage change calculations are further discussed in the link on the
midpoint formula .
2. There is a close connection between the elasticity of demand and the revenue change resulting
from a price change. If the COE is greater than 1, it means the percentage change in quantity is
greater than the percentage change in price. For example, if the COE is 3, a 10 percent increase
in price will lead to a ____ percent decrease in quantity demanded, or to a ____ loss in revenue.
(If you can't fill in the blanks, click here for a discussion of percentage change algebra

Extended elasticity concepts

As well as the price elasticity of demand -- by far the most frequently used elasticity concept -- we can
also speak of:
 1. the income elasticity of demand
defined as the percentage change in quantity demanded divided by the percentage change in
income. Income elasticity can be either positive or negative, so the associated sign is important.
Goods with a negative income elasticity are inferior goods -- as income rises, the quantity of
potatoes purchased may fall, so that potatoes would be inferior goods.

Goods with a positive income elasticity are normal goods; if the income elasticity is not
simply positive but is greater than one the good is classified as a luxury good.
This terminology makes the economist's definition of inferior and luxury goods depend
on observable economic data rather than a subjective judgement.

2. the cross-price elasticity of demand is defined as the percentage change in the quantity of one
good when the price of another good changes. Again, the sign can be either positive or negative.
If positive, the two goods are substitutes -- when the price of coffee goes up, the quantity of tea
also goes up. If negative, the two goods are complements -- when the price of gas goes up, the
number of automobiles purchased goes down.
3. the price elasticity of supply is defined as the percentage change in the quantity supplied
divided by the percentage change in the price of the good. Normally, the long-run elasticity of
supply is greater than the short-run elasticity of supply -- that is, the supply curve will be flatter
in the long run than in the short run.

Elasticity problems

1. Given the following demand schedule:

Demand

PRICE QUANTITY REVENUE

15 10 ____

10 55 ____

5 100 ____

a. Fill in the revenue column; without doing any further computations, is the demand
curve elastic or inelastic? Why?
b. Compute the coefficient of elasticity between a price of $5 and of $15 using the
midpoint formula. If you have forgotten the midpoint formula, review the hypertext link
here
2. Answer the above questions for the following demand schedule:

Demand schedule

PRICE QUANTITY REVENUE

 100 100 -----

300 90 -----

500 80 -----

3. Given the demand curve Q = 200 - 4P

a. Graph the demand curve, showing exactly where it cuts the axes.
b. How much is demanded at a price of 10 dollars? 11 dollars? 9 dollars?
c. Use the above information to find the elasticity of the curve at a price of $10, that is
between prices of $9 and $11. (Note: given a demand curve in algebraic form, we can
find the elasticity at a point by raising and lowering the price by a dollar. We then
construct a table similiar to the tables in the first two probems and compute the
elasticity between the points defined by the given price plus or minus one dollar.)
4. Using the same demand curve, Q = 200 -4P
a. How much is demanded at a price of 40 dollars? at a price of 39 dollars?at a price of 41
dollars?
b. What is the coefficient of elasticity at a price of 40 dollars?
c. How does this compare with the coefficient of elasticity found in the previous problem?
Is elasticity the same anywhere along a straight line demand curve? How does it vary
with price?
5. Given the demand curve Q = 100 - 1/2 P
a. Can we say it is less elastic than the previous demand curve?
b. Is it less elastic than the previous demand curve at a price of 30 dollars?
c. Is it less elastic than the previous demand curve at a price of one dollar?
d. Does elasticity vary along this demand curve? Explain how -- does elasticity increase or
decrease with price? Is this the same as the previous curve?

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income elasticity of demand

Introduction

Income elasticity of demand measures the relationship between a change in quantity demanded and a
change in income. The basic formula for calculating the coefficient of income elasticity is:

Percentage change in quantity demanded of good X divided by the percentage change in real
consumers' income

Normal Goods

Normal goods have a positive income elasticity of demand so as income rise more is demand at each
price level. We make a distinction between normal necessities and normal luxuries (both have a
positive coefficient of income elasticity).

Necessities have an income elasticity of demand of between 0 and +1. Demand rises with income, but
less than proportionately. Often this is because we have a limited need to consume additional
quantities of necessary goods as our real living standards rise. The class examples of this would be the
demand for fresh vegetables, toothpaste and newspapers. Demand is not very sensitive at all to
fluctuations in income in this sense total market demand is relatively stable following changes in the
wider economic (business) cycle.

Luxuries on the other hand are said to have an income elasticity of demand > +1. (Demand rises more
than proportionate to a change in income). Luxuries are items we can (and often do) manage to do
without during periods of below average income and falling consumer confidence. When incomes are
rising strongly and consumers have the confidence to go ahead with “big-ticket” items of spending, so
the demand for luxury goods will grow. Conversely in a recession or economic slowdown, these items of
discretionary spending might be the first victims of decisions by consumers to rein in their spending and
rebuild savings and household financial balance sheets.

Many luxury goods also deserve the sobriquet of “positional goods”. These are products where the
consumer derives satisfaction (and utility) not just from consuming the good or service itself, but also
from being seen to be a consumer by others.

Inferior Goods
Inferior goods have a negative income elasticity of demand. Demand falls as income rises. In a
recession the demand for inferior products might actually grow (depending on the severity of any
change in income and also the absolute co-efficient of income elasticity of demand). For example if we
find that the income elasticity of demand for cigarettes is -0.3, then a 5% fall in the average real
incomes of consumers might lead to a 1.5% fall in the total demand for cigarettes (ceteris paribus).
Within a given market, the income elasticity of demand for various products can vary and of course the
perception of a product must differ from consumer to consumer. The hugely important market for
overseas holidays is a great example to develop further in this respect.

What to some people is a necessity might be a luxury to others. For many products, the final income
elasticity of demand might be close to zero, in other words there is a very weak link at best between
fluctuations in income and spending decisions. In this case the “real income effect” arising from a fall
in prices is likely to be relatively small. Most of the impact on demand following a change in price will
be due to changes in the relative prices of substitute goods and services.
The income elasticity of demand for a product will also change over time – the vast majority of
products have a finite life-cycle. Consumer perceptions of the value and desirability of a good or
service will be influenced not just by their own experiences of consuming it (and the feedback from
other purchasers) but also the appearance of new products onto the market. Consider the income
elasticity of demand for flat-screen colour televisions as the market for plasma screens develops and
the income elasticity of demand for TV services provided through satellite dishes set against the
growing availability and falling cost (in nominal and real terms) and integrated digital televisions.

Definition:

Income elasticity of demand (Ey, here y stands for income) tells us the relationship a product's quantity
demanded and income. It measures the sensitivity of quantity demand change of product X to a change in
income.

Price elasticity formula: Ey = percentage change in Quantity demanded / percentage change in Income

If the percentage change is not given in a problem, it can be computed using the following formula:

Percentage change in Qx = (Q1-Q2) / [1/2 (Q1+Q2)] where Q1 = initial Qd, and Q2 =  new Qd.

Percentage change in Y = (Y1-Y2) / [1/2 (Y1 + Y2)] where Y1 = initial Income, and Y2 = New income.

Putting the two above equations together:

Ey = {(Q1-Q2) / [1/2 (Q1+Q2)] } / (Y1-Y2) / [1/2 (Y1 + Y2)]

Characteristics:

Ey > 1,  Qd and income are directly related. This is a normal good and it is income elastic.

0< Ey<1,  Qd and income are directly related. This is a normal good and it is income inelastic.

Ey < 0, Qd and income are inversely related. This is an inferior good.

 
Example:

If income  increased by 10%,  the quantity demanded of a product increases by 5 %. Then the coefficient
for the income  elasticity of demand for this product is::

Ey = percentage change in Qx / percentage change in Y = (5%) / (10%) = 0.5 > 0, indicating this is a
normal good and it is income inelastic.