Income Elasticity of Demand

This updated topic video looks at income elasticity of demand and the distinction between normal and inferior goods.

Key summary

• Income elastic demand– when demand is highly & positively responsive to a change in income
• Income inelastic demand– when demand only responds a little to a change in income
• Inferior good- a product with a negative income elasticity of demand
• Normal good– any product with a positive income elasticity of demand
• Luxury good– a product with a highly positive income elasticity of demand (YED > +1)

Importance of income elasticity (YED) for businesses

• Knowledge of YED helps firms to predict the effect of changes in the (macro) economic cycle on their sales.
• Luxury products with a high-income elasticity see greater sales volatility over a business cycle than necessities where demand is less sensitive to changes in the economic cycle
• Important to have a diversified product range
• Higher value-added products increase profit margins – they have high YED and low PED

What are inferior goods?

If, following an increase in real income, less of the good is purchased, then the good is an inferior good.

Inferior goods have a negative YED, i.e. YED < 0

When real incomes are rising during a period of economic growth, then demand for inferior goods will fall causing an inward shift of the demand curve.

When real incomes are falling during a period of recession or more generally, if wages are rising more slowly than prices, then market demand for inferior goods will rise