2.5 - Income Elasticity of Demand
The meaning and formula for income elasticity of demand
Income elasticity of demand (YED) measures how much the quantity demanded of a product changes in response to a shift in consumers' income.
Formula for calculating YED
Where:
- % change in quantity demanded = The percentage variation in the amount of a good consumers wish to buy
- % change in income = The percentage variation in consumers' earnings or disposable income
YED can be positive or negative, depending on whether demand rises or falls with income.
Worked example - Calculating income elasticity of demand
When average household income rises from £40,000 to £44,000 per year, the quantity demanded for a particular brand of coffee increases from 800 units to 896 units per month. Calculate the YED for this coffee.
Step 1: Identify the values
- Original income = £40,000
- New income = £44,000
- Original quantity demanded = 800 units
- New quantity demanded = 896 units
Step 2: Calculate the percentage changes
% change in income = ((£44,000 - £40,000) / £40,000) × 100 = 10%
% change in quantity demanded = ((896 - 800) / 800) × 100 = 12%
Step 3: Apply the YED formula
Step 4: Interpretation
A YED of 1.2 indicates that demand for this coffee is income elastic, meaning it responds more than proportionately to income changes.
Income elastic and inelastic demand
The value of YED determines whether demand is elastic or inelastic to income changes.
Income elastic demand
Demand is responsive when the percentage change in quantity demanded exceeds the percentage change in income. This gives a YED greater than 1 (YED > 1).
Income inelastic demand
Demand is not very responsive when the percentage change in quantity demanded is less than the percentage change in income. This results in a YED less than 1 (YED < 1).
The classification of goods using YED
YED values, including their sign (positive or negative), help classify goods into categories.
Types of goods based on YED values
| Type of good | YED value | Description | Examples |
|---|---|---|---|
| Normal goods | Positive, between 0 and 1 | Quantity demanded rises as income increases, but less than proportionately. | In developing Southeast Asian countries, dairy products where demand grows steadily with rising household incomes. |
| Inferior goods | Negative | Quantity demanded falls as income rises (or rises as income falls), as consumers switch to better alternatives. | Low-quality frozen meals or instant powdered soups, replaced by higher-quality options when incomes increase. |
| Necessity goods | Positive, close to zero | A subtype of normal goods where quantity demanded changes little with income shifts, as these are essential items. | Basic cooking oil, salt, or potatoes, consumed consistently regardless of income levels. |
| Superior/luxury goods | Positive, greater than 1 | A subtype of normal goods where quantity demanded rises more than proportionately with income, often seen as non-essentials. | Fine dining experiences or premium wines, with demand surging significantly when incomes grow. |
How income levels affect the classification of goods
The way a good is classified using YED is not fixed; it can vary depending on consumers' income levels.
Influences of income on good classification:
- Low-income households - Goods like basic grains may act as necessities (YED positive but close to zero).
- High-income households - These goods might turn inferior (YED negative), as wealthier consumers opt for premium alternatives, reducing demand for basics.
- Contextual variations - A necessity for a low-income family might be a normal good for a wealthier one.