Income elasticity of demand (YED) shows the relationship between consumer incomes and quantity demanded. Income (Y) is a key determinant of demand, with the demand for many goods and services highly sensitive to income.
YED can be calculated using the formula:
Consider the schedule below:
From the schedule we can see that for all three goods, the quantity demand varies with income. However, in the first two cases demand rises with income, and in the case of good 3 it falls. YED can be used to discover whether goods are considered 'normal' or 'inferior'.
With 'normal' goods, income and quantity demanded are positively related - increased income means more demand and decreased income means less demand.
With 'inferior' goods, the opposite is true - when income increases, demand falls and when income decreases, demand rises.
While inferior goods are often goods which are of lower quality, it is more likely that inferior goods are simply relatively cheap basic necessities, such as bread, pasta and rice. As incomes rise, consumers are likely to switch to more expensive foods.
In the case of Good 1, as incomes rise by 33.3% (from $1500 to $2000), demand for Good 1 rises by 33.3% (from 30 to 40). In this case YED is positive, and the good is a normal good with a unit elasticity.
For Good 2, which is also a normal good, demand is more responsive, with YED of (+) 2.0. This signifies that the good is more likely to be a luxury than a basic necessity.
In contrast, demand for Good 3 falls indicating it is an inferior good.
Demand-income curves, also called Engel Curves, after German statistician Ernst Engel, can be used to illustrate the relationship between income and quantity demanded, and can help identify when goods are normal or inferior goods.
Gathering data on income elasticities is important for producers and for government agencies.
A key aspect to this is understanding that changes in real incomes across the economy will reflect changes in the business (or economic) cycle.
For example, during a growth phase in GDP, rising income mean that households are more likely to allocate more of their income towards elastically demanded goods - such as holidays, cars and electronic products. In contrast, in a downturn or recession individuals may choose to save more of their income or cut back on 'discretionary' purchases.
Hence, it makes sense for producers to diversify and offer a range of products so that whatever the point in the business cycle, sales can be made. Hence, typically, a car producer will offer budget cars as well as mid-range and expensive cars, and in this way it can have some confidence that, whatever the state of the macro-economy, it can still sell its products.
Similarly, government agencies can use data on income elasticities to inform how they plan to allocate their budgets. In the growth phase of GDP individuals are more likely to go on holidays, and purchase electronic products.
This means that more pubic resources may need to be allocated towards transport infrastructure, and to waste disposal as households acquire more packaging associated with purchasing electronic goods.