Income Elasticity of Demand and its implications

Definition

Income elasticity of demand, which means a measure of how mach the quantity demanded of a good responds to a change in consumer’s income, computed as the percentage change in quantity demanded divided by the percentage change of income.

The calculating formula is as the percentage change in quantity demanded divided by the percentage change in income. For example, if, in response to a 10% increase in income, the demand for a good increased by 20%, the income elasticity of demand would be 20%/10% = 2. It measures how the quantity demanded changes as the consumer income changes.

Normal goods and inferior goods

From the definition above, we can see the close relation between these two elements-the percentage change in quantity demanded and the percentage change in income.

The change of either element will affect the income elasticity of demand. Generally speaking, quantity demanded of most stuffs and income move in the same direction. We give such things a name-normal goods. For instance, food, clothing or diamond, provided that people’s income rises, the quantity demanded of these goods will climb. On the contrary, if quantity demanded and income of most stuffs move in the opposite direction, we call them inferior goods, such as bus rides, fast food. If people’s situations become better, they would choose to ride a car themselves instead of riding bus.

The major determinant of income elasticity of demand is the degree of ‘necessity’ of the goods.

The sizes of income elasticity of demand differ from different stuffs. Things like food and clothing, apt to have smaller income elasticity than luxury things like jewelry, car and Foie Gras. Rice is necessary in our daily life, no matter how poor you are, you will manage to buy it to meet our daily needs. But if you just have several pennies, you will not go to a luxury restaurant to have a try at Foie Gras. For a conclusion, the demands of luxury things change a lot when people’s incomes fluctuate, but this never happens to necessary goods in our life. So, if income elasticity of demand of a commodity is less than 1, it is a necessity good. If the elasticity of demand is greater than 1, it is a luxury good or a superior good.

Inferior goods’ demand falls as consumer income increases

Positive and negative income elasticity of demand

The income elasticity of demand is divide into two parts-Positive and negative income elasticity of demand. A negative income elasticity of demand is associated with inferior goods; an increase in income will lead to a fall in the demand and may lead to changes to more luxurious substitutes. A positive income elasticity of demand is associated with normal goods; an increase in income will lead to a rise in demand. But there is also an exceptive situation.A zero income elasticity (or inelastic) demand occurs when an increase in income is not associated with a change in the demand of a good. These would be sticky goods.

The income elasticity of demand of the same commodity changes in different stages

The income elasticity of demand of the same commodity changes in different stages. When a brand new product is presented to the public, the income elasticity of demand will be greater than 1. Since the supply of a new product is totally limited. People haven’t got the effective approach to increase the supply. That is why new product has a higher price. So some people who is not so rich couldn’t afford it. I can think of no better illustration to explain the principle above but rice. When people discover it, it was luxury food and just can supply to the rich because the quantity is quite limited. Only if you have enough money, can you afford buying it. Those who are poor can only live on the wild fruits. Day by day, the agriculture develops rapidly, which broadens the supply of rice. Nowadays, rice becomes necessity in our daily life. The income elasticity of demand has been less than 1. Here comes the inclusion, when the productivity and people’s income improve, some commodity will become necessity for people, and the income elasticity of demand will be less than 1.

The application of income elasticity of demand

Income elasticity of demand can be used as an indicator of industry health, future consumption patterns and as a guide to firm investment decisions. Income elasticity of demand is an important concept to firms considering the future size of the market for their product. If the product has a high income elasticity of demand, sales are likely to expand rapidly as national income rises, but may also fall significantly if the economy moves into recession.

Manufacturers should take good use of income elasticity of demand. Before deciding how many products they will manufacture, they should analyze income elasticity of demand of the product. If the income elasticity of demand is greater than 1, in such a situation, quantity demanded of most stuffs and income move in the same direction.

If the condition of national income is positive, firms can take production expansion into consideration. On the contrary, if income elasticity of demand is great, but the national economy is tough, the manufacturer should reduce the production.

In another crucial situation, the income elasticity of demand also play its important role when the firms are making decision whether they could raise the price of the product. As the form shown below, they can get lots of message from it.

Price rise

Income effect

Normal good

Negative

Inferior good

Positive

Related law-Engel’s Law

According to the analysis above, we can draw a conclusion that income elasticity of demand of necessity is greater than luxury good. The famous statistician Ernst Engel gave a law to describe the phenomenon¼Œit is called Engel’s Law. It states that the percentage of income allocated for food purchases decreases as income rises. As a household’s income increases, the percentage of income spent on food decreases while the proportion spent on other goods (such as luxury goods) increases. For example, a family that spends 25% of their income on food at an income level of $50,000 will spend $12,500 on food. If their income increases to $100,000, it is not likely that they will spend $25,000 (25%) on food, but will spend a lesser percentage while increasing spending in other areas.

People measure the development of a certain country with the Engel’s coefficient. If the Engel’s coefficient relatively greater than the average, we can arrive at the conclusion that the country is still not so rich, people still spend most of their income in the necessity. The country should pay its focus in how to improve its economy to improve the people’s living standard.

Income elasticity of demand is quite a significant concept for a nation’s economy. It is used to measure how the quantity demanded changes when the consumer income changes. Not only meaningful for the country, but also for the manufacturers, it is an important reference. Once if we take good use of it, can we have a better grasp of the manufacture and a good understanding of a country improvement.