Income Elasticity Of Demand

Income elasticity of demand can be defined as the impact of consumer income on product demand. Businesses use this metric to predict future demand and to understand consumer buying behaviors. In addition, income elasticity signifies the nature of a product.

Income elasticity is measured using the income elasticity formula: the percentage change in aggregate demand is divided by the percentage change in income. This value can be positive (high, unitary, or low), negative, or even zero. This metric is more useful for the government than for manufacturers. Unlike price, manufacturers have no control over income.

• The income elasticity of demand is the relationship between a change in aggregate demand and a change in consumer income.
• There is no fixed relationship; income elasticity can be high, unitary, low, zero, or even negative.
• When there is a visible decrease in income, a large percentage of the population is forced to purchase inferior alternatives.
• Often income elasticity is criticized for its inaccuracy in real-world applications. This is because, in real-world scenarios, external factors play a significant role. But these external forces are not accounted for in this method.

The income elasticity of demand is a fundamental concept in economics; it signifies consumer demand. Businesses use this metric to make informed decisions (in combination with other factors). The government, too, can study demand about the population's income.

So, let's look at the factors affecting income elasticity:

• Necessity: Essential goods have constant demand; normal and luxury goods show positive elasticity.
• Units: It refers to the quantity (of a particular product) consumed by one household within a month or year.
• Price: If the price of a commodity is high, consumers go for inferior goods; the demand for inferior substitutes rises.
• Real income: Inflation and taxation affect disposable income. This, in turn, dictates how much money is left for spending.

Let us look at the income elasticity of demand types.

Depending on the measurement, income elasticity is classified into three—positive, negative, and zero. Further positive elasticity could be higher, unitary, or lower.

• Negative elasticity – An increase in income produces a counter-result, a fall in demand. Hence, the elasticity is less than zero. For example, inferior goods show negative elasticity. As people's incomes rise, they buy better-quality goods.
• Zero elasticity – Here, demand is unresponsive to a hike in income. Therefore, even if income increases, demand will not. This can be seen with essential commodities like drinking water, food, etc. People consume these essential goods even if their income is less. Thus, a rise in income does not increase demand any further.
• Low elasticity – An increase in income causes a less than proportionate increase in demand. Thus, the elasticity is less than one but greater than zero.
• Unitary elasticity – The rise in income leads to a proportionate rise in demand. Here, elasticity equals one.
• High elasticity – A small increase in income leads to a more than proportionate increase in demand. The value will be greater than one. Luxury goods show a positive income elasticity of demand. If income is high, people purchase premium products. The degree of increase, however, depends on the price of the good and the exact increase in income.

Let us look at the income elasticity of demand formula.

The income elasticity of demand formula determines the percentage change in the demand for goods or services with the fluctuation in consumers' real income. It measures how a change in real income impacts buying behavior and product demand. It is expressed as follows:

Given below are some income elasticity of demand examples.

Example #1

Determine the measurement of income elasticity of demand based on given information.

First, we determine individual values required for the income elasticity formula. We compute the percentage change in demand as follows:

• Percentage change in demand = x 100
• Percentage change in demand = 37.5%

Then, we compute the percentage change in income:

• Percentage change in income = x 100
• Percentage change in income = 25%

Now, we apply the values in the income elasticity formula:

Income elasticity = 37.5%/ 25%

Income elasticity = 1.5

Thus, income elasticity is high.

Example #2

Inflation is a peculiar economic condition. On the one hand, it is a cause for concern; on the other, it is a necessity. One such issue is income inequality. People with lesser income pay more for the same goods. Along with job losses, this leads to a fall in income for a large percentage of society.

The New York Times estimates that 60% of the spending comes from the top 40% of earners. So, what happens to the remaining 60%? With a fall in real income (owing to inflation), low-income sections of society switch to inferior goods. As a result, the demand for inferior alternatives rises, and the demand for regular goods plummets.

Let us look at the income elasticity of the demand graph.

Regarding income elasticity, there is no fixed graphical representation, as it differs for different types of goods. Instead, there are three different graphs – positive, negative, and zero elasticity.

#1 - Positive Elasticity

The graph is an upward-sloping line (positive slope). The exact degree of slope depends on the value of elasticity. The unitary elasticity slope would pass through the origin when extended. A low elasticity slope would make less than 45^o, and a high elasticity slope would make more than 45^o.

#2 - Negative Elasticity

The graph is downward sloping (negative slope). It shows the inverse relationship between demand and income.

#3 - Zero Elasticity

The graph is a vertical line parallel to the Y-axis, indicating the non-existence of any relation between demand and price.

Here are the merits and demerits of income elasticity:

Advantages

• It is an important tool for businesses; firms can use this data to position their products better.
• Inflation paves the way for an increase in income and wages. Thus, businesses should know what would affect their product when consumers' income rise. Thus, income elasticity predicts the future demand for a product.
• Governments also use income elasticity to understand the impact of income on people’s buying habits.

Disadvantages

• Unlike the price elasticity of demand, firms do not have any control over consumers' real incomes. At the most, firms can study the demand, make predictions, and employ the best decisions.
• Another significant demerit is that the income elasticity is not all-inclusive. There are factors outside this concept that can influence demand. Therefore, an entity studying income elasticity should consider external factors and adopt a comprehensive approach.

The price elasticity of demand establishes the relationship between price and demand. It is used to determine the impact of price change on product demand.

Now, let us compare income elasticity and price elasticity.

This article has been a guide to what is Income Elasticity of Demand. We explain its types, examples graph (positive/negative), advantages, and disadvantages. You can learn more about it from the following articles -

• Elasticity Coefficient
• Price Elasticity of Supply
• Price Discrimination