How responsive changes in income affect demand is income elasticity (income elasticity of demand). Income is one of the determinants of demand for a product—the demand quantity changes when income changes.
In general, the quantity of demand increases with an increase in consumer income. Because they have more money, they will shop more. Hence, the quantity of demand has a positive relationship with income.
But, not all items show this positive relationship. For some products, the demand increases when income decreases.
What is income elasticity
Income elasticity is a measure of demand sensitivity when consumer incomes change. Remember, when measuring it, we assume other factors are constant (ceteris paribus).
What are those factors? Three of them are:
- Own-price of the item
- Price of complementary goods
- Price of substitute goods
- Taste and consumer preferences
For most goods, an increase in income causes an increase in the quantity of demand. But, in some instances, such a relationship does not apply.
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How to calculate the income elasticity of demand
Calculating the income elasticity of demand is simple. The technique is like calculating the cross-price elasticity or the own-price elasticity.
To get it, you need to compare the percentage change in the demand quantity for a product with the percentage change in income. And mathematically, the formula for income elasticity is:
Income elasticity (IE) =% Demand quantity of product X /% Changes in income
Based on its elasticity, we classify goods into two groups:
- Normal goods: elasticity more than 0 (IE> 0). The quantity of demand increases when the income rises.
- Inferior goods: elasticity less than 0 ((IE <0). An increase in income causes a decrease in the quantity of demand.
What are normal goods
Normal goods have a positive income elasticity (more than zero). That shows that when income rises, the quantity of demand will also increase.
Normal goods consist of two subcategories, based on the significance of changes in the quantity of demand. Both are “
- Luxury goods
Luxury goods are is more sensitive to changes in consumer income since have an income elasticity of more than one (IE> 1). When income increases by 10%, the demand will increase by more than 10x%. Hence, we call luxury goods elastic in income.
The next, necessities have an income elasticity of more than zero but less than one (0<IE<1). If income rises by 10%, the demand will increase by less than 10%. It shows necessities are inelastic in income—the closer to zero, the more inelastic the demand.
What are inferior goods
Inferior goods are types of goods with a negative income elasticity (less than zero). Demand is inversely related to income. When consumer income rises, their demand falls.
What are examples of normal goods and inferior goods
For example, with your current income, rice is a necessity for you. When your income increases slightly, you still buy it, even if it’s not too high.
Say, your current income has gone up 10% than before. You begin to think of replacing rice with meat to meet the quality of the food you consume. In this income range, rice is no longer a necessity item, but an inferior item.
In short, the categorization of goods as inferior or normal goods depends on your income. Classification also varies between individuals, depending on their income. A smartphone might be a luxury for you, but it is a necessity for someone else.
Likewise, cars can be a luxury item for low-income individuals. But, it is a necessity for wealthy individuals.
What is the effect of income elasticity on the demand curve
From the previous discussion, we know that increased income does not increase the quantity of demand and shifts the curve to the right. That depends on the type of goods, whether normal goods or inferior goods.
For normal goods, an increase in income results in an increase in demand and shifts the demand curve to the right.
Conversely, for inferior goods, higher-income causes a decrease in demand. That causes a shift in the demand curve to the left.
What is the application of income elasticity in business
When the economy prospered, the luxury goods business saw a bright outlook for demand. Higher consumer income will encourage increased demand. And, companies will avoid producing inferior goods because their demand will fall.
Furthermore, during the economic crisis, the company might not generate much revenue. That’s because the fall in consumer income will cause the demand for luxury goods to fall.
For producers of consumer goods, they can increase or decrease prices, despite the current adverse economic conditions. Consumers will continue to buy goods. Because demand is inelastic, changes in demand will not be as significant as changes in demand for goods, ceteris paribus.