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Income elasticity of demand


Income elasticity of demand (YED) shows the effect of a change in income on quantity demanded. Income is an important determinant of consumer demand, and YED shows precisely the extent to which changes in income lead to changes in demand. YED can be calculated using the following equation:

% change in (∆) quantity demanded

 % change in (∆) income (Y)

Normal goods

When the equation gives a positive result, the good is a normal good. A normal good is one where demand is directly proportional to income. For example, if, following an increase in income from £40,000 to £50,000, an individual consumer buys 40 DVD films per year, instead of 20, then the coefficient is:

+100/+25 

= (+) 4.0 

The positive sign means that the good is a normal good, and because the coefficient is greater than one, demand for the good responds more than proportionately to a change in income. This indicates the good is not a necessity like food, and would be considered a relative luxury for this individual.

Inferior goods

When YED is negative, the good is classified as inferior. For example, if, following an increase in income from £40,000 to £50,000, a consumer buys 180 loaves of bread per year instead of 200, then the YED is:

-10/+25 

= (-) 0.4 

The negative sign means that the good is inferior, and, because the coefficient is less than one, demand for the good does not respond significantly to a change in income. This indicates that the good is not particularly inferior compared with a good which has a YED of  > (-)1.

The sign and the number provide different information about the relationship between income and demand. Income elasticity of demand can also be illustrated by Engel curves.

Video

Why does a firm want to know YED?

There several reasons why a firm would want to know YED, including the following:

Sales forecasting

A firm can forecast the impact of a change in income on sales volume (Q), and sales revenue (P x Q).

For example, a hypothetical car manufacturer has calculated that YED with respect to its luxury car is (+) 3.8, and it has also undertaken research to discover that consumer incomes will rise by 2% next year. It can now predict the impact of this change.

Exercise

Using the YED equation, calculate the effect on sales.

The same producer sells a small car with a YED of (-) 5.  Using the YED equation, and assuming income also increases by 2%, calculate the effect on sales. 

Answers 

Pricing policy

Knowing YED helps the firm decide whether to raise or lower price following a change in consumer incomes. If incomes are falling and YED is positive, a reduction in price might help compensate for the reduction in demand.

Diversification

Firms can diversify and offer a range of goods with different YEDs to spread the risks associated with changes in the level of national income. For example, a car manufacturer may produce cars with a range of YED values, so that sales are stabilised as the economy grows and declines.

YED and the business cycle

Changes in real national income tend to be cyclical. The demand for normal goods increases when the economy is expanding, but decreases when the economy is contracting. Conversely, the demand for inferior goods is counter-cyclical.

YED and the trade cycle

The higher the positive value for YED, the greater the effect of a change in national income on consumer demand.