Income Elasticity of Demand 'What is the 'Income Elasticity of Demand?

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. (Very Important)

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 fewer inferior goods. A typical example of such type of product is margarine, which is much cheaper than butter.

Interpretation of Income Elasticity of Demand 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.

Interpretation of Income Elasticity of Demand Basically, a negative income elasticity of demand is linked with inferior goods, meaning rising incomes will lead to a drop in demand and may mean changes to luxury goods. But a positive income elasticity of demand is linked with normal goods. In this case, a rise in income will lead to a rise in demand.

Types of Income Elasticity of Demand There are five types of income elasticity of demand High: A rise in income comes with bigger increases in the quantity demanded. Unitary: The rise in income is proportionate to the increase in the quantity demanded. Low: A jump in income is less than proportionate than the increase in the quantity demanded. Zero: The quantity bought/demanded is the same even if income changes. Negative: An increase in income comes with a decrease in the quantity demanded.