EFA (43): Income elasticity of demand

Elasticity of demand is a key concept in economics. It is a measure of the responsiveness of demand for goods (or services) to other changes.

The most common concept is price elasticity of demand, which measures how the demand for a good changes when its price goes up or down. We look at this in more detail here.

But this week, in the 43rd item in our Economics for Amateurs (EFA) series, we look at income elasticity of demand.

As the name suggests, this is a measure of the responsiveness of the demand for a particular good to changes in people's income.

The income elasticity of demand is measured as follows: the percentage change in demand divided by the percentage change in income.

Economists distinguish betweeen various types of goods (or services) according to their income elasticity of demand. The first important point is whether people spend more or less on a particular good when their income rises.

• Normal goods have a positive income elasticity of demand. In other words, as income rises, we spend more on these goods.
• Inferior goods have a negative income elasticity of demand. As income rises, we spend less on these goods.These tend to be low-quality goods, such as very cheap foodstuffs.

Within normal goods, there is another distinction: one that depends on how high the income elasticity is:

• A necessity is a good with an income elasticity of less than one. This means that that the percentage increase in demand is less than the percentage change in income. Food as a whole is normally a necessity.
• A luxury good is one with an income elasticity of more than one. In other words, the percentage change in demand is greater than the change in income. These tend to be high-quality goods, such as organic food or expensive cars.
  

As our incomes rise, we spend a greater proportion of our incomes on luxury goods and a lower proportion on inferior goods and necessities.

Estimating income elasticities of demand is important for economists. It can help them to predict how the pattern of demand for goods and services will change as incomes rise (or fall). For a more detailed discussion, see here.