It is quite common among the working class to enjoy with their family whenever they get a hike. Their first instinct is to buy something new, pamper themselves, or share the experience with their family. Such spree of buying something has a significant impact on the demand for such products. This is what income elasticity of demand is. Let us look more into the details of the income elasticity of demand.
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What is the Income Elasticity of Demand?
According to the Income elasticity of demand definition, it is the elasticity in demands resulting from the changes in the income of the customers. It is expressed as the percent change in the demanded quantity per percent change in income. Mathematically, it is expressed by the income elasticity of demand formula.
Income elasticity of demand (YED)= %change in quantity/ % change in income
If the YED for a particular product is high, it becomes more responsive to the change in consumer's income. The first step to measure YED is to categorize the goods as normal and inferior. It is to be kept in mind that the YED can be positive, negative, or even unresponsive.
How to Find Income Elasticity of Demand?
The best way to understand the topic is to measure the demand responsiveness with respect to the income of the customer. In most cases, the increase in income is directly related to demand. Therefore, the demand for the product will be a nice scenario for how to find income elasticity of demand.
Income Elasticity of Demand: Types
In general, there are five kinds of income elasticity of demand, and these are:
High- An increase in income is associated with an increase in demand.
Unitary- An increase in income is proportionate to the increased demand for quantity.
Low- A rise in income is less proportionate than the demand increase of the quantity.
Zero- A demand quantity remains the same, although income changes.
Negative- A rise in income is related to a decline in the demanded quantity.
The best way to assign the different kinds is by using an income elasticity of demand calculator.
Normal Goods
As said earlier, the income elasticity of demand depends on the quality of the product. For measuring income elasticity, the coefficient is YED. A positive value of YED indicates that the product has an elastic income. Most goods have positive YED. This indicates that when the income increases, the demand also increases.
These normal goods are differentiated into normal luxuries and normal necessities. Compared to the normal luxurious goods, the normal necessity goods have a smaller margin of elasticity in income. The normal necessities goods include fuel, medicine, and milk. Any income elasticity of demand example for normal necessity goods has a YED value between 0 and 1. The demand for normal necessity goods is not controlled by a change in the income of the consumers or changes in price. For a normal necessity product, the percentage of change in demand is less than that in the consumer's income.
Normal luxuries are considered to be highly elastic in income. Luxury goods include jewelry and high-end electronics. Income elasticity of demand example for normal luxury will be to buy HD television or high-tech mobiles with the bonus that the consumer receives.
For normal luxury products, the change in demand percentage is more proportionate to the changes related to income. However, it must be considered that the luxury concept is contextual, depending on the consumer's circumstances.
Inferior Goods
Inferior goods are considered to have a negative income elasticity. The YED value for inferior goods is less than zero. For inferior goods, the demand for goods decreases when the income of the consumer increases. The decrease in demand for inferior goods is attributed to the presence of superior alternatives. For example, public transports are considered to be inferior goods, if the consumer decides to take a cab. Generally, it is found that when there is an increase in income, the consumer prefers to avoid inferior goods, and their demand decreases. However, when the income decreases, the demand for inferior goods increases and the demand curve exhibits an outward swing. Another income elasticity of demand example will be the use of margarine. Butter is the costlier option, but when the income decreases, people opt for margarine, which is the cheaper alternative to butter.
FAQs on Understanding Income Elasticity of Demand
1. What is income elasticity of demand and how is it calculated?
Income elasticity of demand (YED) is an economic measure of how responsive the quantity demanded for a good or service is to a change in the real income of consumers, keeping all other factors constant. It helps in understanding consumer behaviour. The formula to calculate it is:
YED = (% Change in Quantity Demanded) / (% Change in Income).
The resulting value helps classify goods into different categories like normal, inferior, or luxury.
2. What are the main types of income elasticity of demand?
There are five primary types of income elasticity of demand, each indicating a different relationship between consumer income and demand for a product:
- High Elasticity (YED > 1): Demand increases more than proportionally to a rise in income. These are typically luxury goods.
- Unitary Elasticity (YED = 1): Demand increases in the same proportion as the rise in income.
- Low Elasticity (0 < YED < 1): Demand increases less than proportionally to a rise in income. These are normal necessities.
- Zero Elasticity (YED = 0): Demand does not change at all when income changes. This applies to absolute necessities like salt.
- Negative Elasticity (YED < 0): Demand decreases as income rises. These are called inferior goods.
3. How does income elasticity help differentiate between normal and inferior goods?
The sign of the income elasticity of demand (YED) coefficient is the key differentiator. A positive YED indicates a normal good, meaning that as consumer income increases, the demand for the good also increases. Conversely, a negative YED signifies an inferior good. For these goods, as consumer income rises, the demand falls because consumers switch to better quality, more expensive alternatives.
4. What does an income elasticity of demand (YED) between 0 and 1 indicate about a good?
An income elasticity of demand (YED) value between 0 and 1 signifies that the good is a normal necessity. The positive value means demand rises with income, but the value being less than 1 indicates that the demand is income-inelastic. This means a 10% increase in income might lead to only a 3% increase in demand. Examples include essential food items like milk, bread, and fuel, for which consumption increases only slightly even with a significant rise in income.
5. Why is it important for businesses to understand the income elasticity of demand?
Understanding income elasticity is crucial for business strategy and planning. It helps a firm to:
- Forecast Sales: During economic booms (rising incomes), businesses selling luxury goods (high YED) can expect a surge in sales. During recessions (falling incomes), firms selling inferior goods may see increased demand.
- Set Pricing Strategies: Knowledge of YED helps in making informed decisions about product positioning and pricing for different income segments.
- Manage Production and Inventory: Businesses can adjust production levels based on economic forecasts and the income elasticity of their products to avoid overproduction or stockouts.
6. What is the key difference between a normal necessity and a luxury good in terms of income elasticity?
The key difference lies in the degree of responsiveness to income changes. While both are normal goods (positive YED), their elasticity values differ significantly. A normal necessity has an income elasticity between 0 and 1, meaning demand rises less than proportionally with income. A luxury good has an income elasticity greater than 1, meaning demand rises more than proportionally with income. For example, a 20% income increase might lead to a 5% increase in demand for wheat (necessity) but a 30% increase in demand for foreign holidays (luxury).
7. Can a good be a 'normal good' for one person and an 'inferior good' for another? Explain.
Yes, the classification of a good as normal or inferior is highly contextual and depends on an individual's income level and preferences. For instance, public transportation could be a normal good for a student with a low income; as their income rises slightly, they might use it more. However, for a middle-income manager, public transportation could be an inferior good. As their income increases, they would likely switch to using a personal car or taxi services, thus decreasing their demand for public transport.
8. What does a zero income elasticity of demand signify?
A zero income elasticity of demand (YED = 0) signifies that the quantity demanded for a product remains completely unchanged regardless of any change in consumer income. This is characteristic of absolute necessities or goods where consumption is fixed due to habit or need. A classic example is salt; a person's income doubling will not cause them to consume double the amount of salt. Similarly, essential life-saving medicines would have zero income elasticity as their consumption is dictated by medical need, not income.
