Unit 1 Micro: Income Elasticity of Demand

A revision blog on income elasticity of demand

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

% change in demand divided by the % change in income

(a) Normal Goods

Normal goods have a positive income elasticity of demand so as consumers’ income rises more is demanded at each price i.e. there is an outward shift of the demand curve

1. Normal necessities have an income elasticity of demand of between 0 and +1 for example, if income increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0.4. Demand is rising less than proportionately to income.

2. Luxury goods and services have an income elasticity of demand > +1 i.e. demand rises more than proportionate to a change in income – for example a 8% increase in income might lead to a 10% rise in the demand for new kitchens. The income elasticity of demand in this example is +1.25.

(b) Inferior Goods

Inferior goods have a negative income elasticity of demand meaning that demand falls as income rises. Typically inferior goods or services exist where superior goods are available if the consumer has the money to be able to buy it. Examples include the demand for cigarettes, low-priced own label foods in supermarkets and the demand for council-owned properties.

The income elasticity of demand is likely to be strongly positive for
• Fine wines and spirits, high quality chocolates and luxury holidays overseas.
• Sports cars
• Consumer durables - audio visual equipment, smart-phones
• Sports and leisure facilities (including gym membership and exclusive sports clubs).

In contrast, income elasticity of demand is likely to lower and possibly negative for
• Staple food products such as bread, vegetables and frozen foods.
• Mass transport (bus and rail).
• Beer and takeaway pizza!
• Income elasticity of demand is negative (inferior) for cigarettes and urban bus services.

Product ranges and longer term trends

Income elasticity of demand will vary within a product range. For example the Yed for own-label foods in supermarkets is less for the high-value “finest” food ranges.

There is a general downward trend in the income elasticity of demand for many basic products, particularly foodstuffs. One reason is that as a society becomes richer, there are changes in tastes and preferences. What might have been considered a luxury good several years ago might now be regarded as a necessity? How many of you regard a Sky sports subscription or an iPhone5, an iPad3 or a new Blackberry as a necessity?

How do businesses make use of estimates of income elasticity of demand?

Knowledge of income elasticity of demand helps firms predict the effect of an economic cycle on sales. Luxury products with high income elasticity see greater sales volatility over the business cycle than necessities where demand from consumers is less sensitive to changes in the cycle.

Income elasticity and the pattern of consumer demand

As we become better off, we can afford to increase our spending on different goods and services. The income elasticity of demand will also affect the pattern of demand over time.

* For normal luxury goods - income elasticity of demand exceeds +1, so as incomes rise, the proportion of a consumer’s income spent on that product will go up.

* For normal necessities (income elasticity of demand is positive but less than 1) and for inferior goods (where the income elasticity of demand is negative) – then as income rises, the share or proportion of their budget on these products will fall

* For inferior goods as income rise, demand will decline and so too will the share of income spent on inferior products.