Income Elasticity of Demand

A Beginner's Guide to Elasticity: Price Elasticity of Demand introduced the basic concept and illustrated it with a few examples of price elasticity of demand. 

A Brief Review of Price Elasticity of Demand

The formula for price elasticity of demand is:

 Price Elasticity of Demand (PEoD) = (% Change in Quantity Demanded) ÷ (% Change in Price)

The formula quantifies the demand for a given as the percentage change in the quantity of the good demanded divided by the percentage change in its price.  If the product, for example, is aspirin, which is widely available from many different manufacturers, a small change in one manufacturer's price, let's say a 5 percent increase, might make a big difference in the demand for the product. Let's suppose that the decreased demand was a minus 20 percent, or -20%. Dividing the decreased demand (-20%) by the increased price (+5 percent) gives a result of -4. The price elasticity of demand for aspirin is high -- a small difference in price produces a significant decrease in demand. 

Generalizing the Formula

You can generalize the formula by observing that it expresses the relationship between two variables, demand and price. A similar formula expresses another relationship, that between the demand for a given product and consumer income

Income Elasticity of Demand = (% Change in Quantity Demanded)/(% Change in Income)

In an economic recession, for example, U.S. household income might drop by 7 percent, but the household money spent on eating out might drop by 12 percent. In this case, the income elasticity of demand is calculated as 12 ÷ 7 or about 1.7. In other words, a moderate drop in income produces a greater drop in demand.

In the same recession, on the other hand, we might discover that the 7 percent drop in household income produced only a 3 percent drop in baby formula sales. The calculation in this instance is 3 ÷ 7 or about 0.43. 

what you can conclude from this is that eating out in restaurants is not an essential economic activity for U.S. households -- the elasticity of demand is 1.7, considerably great than 1.0 -- but that buying baby formula, with an income elasticity of demand of 0.43, is relatively essential and that demand will persist even when income drops.  

Generalizing Income Elasticity of Demand

Income elasticity of demand is used to see how sensitive the demand for a good is to an income change. The higher the income elasticity, the more sensitive demand for a good is to income changes. A very high-income elasticity suggests that when a consumer's income goes up, consumers will buy a great deal more of that good and, conversely, that when income goes down consumers will cut back their purchases of that good to an even greater degree.  A very low price elasticity implies just the opposite, that changes in a consumer's income have little influence on demand.

Often an assignment or a test will ask you the follow-up question "Is the good a luxury good, a normal good, or an inferior good between the income range of $40,000 and $50,000?" To answer that use the following rule of thumb:

• If IEoD > 1 then the good is a Luxury Good and Income Elastic
• If IEoD < 1 and IEOD > 0 then the good is a Normal Good and Income Inelastic
• If IEoD < 0 then the good is an Inferior Good and Negative Income Inelastic

The other side of the coin, of course, is supply.