Income elasticity is an important concept for businesses and economists to understand. It is a measure of how the demand for a good or service changes in response to changes in income. It is an important factor in understanding the relationship between income and demand, as it can tell businesses what types of goods and services people will buy when their income increases. Income elasticity can also be used to predict how demand might change in times of economic growth or recession. It is a valuable tool for businesses to understand their customer base and to make informed decisions about pricing and marketing. Knowing the income elasticity of a good or service can help businesses make decisions about the type of goods and services they should offer, pricing strategies, and marketing campaigns. It can also provide valuable insight into the economic dynamics of a particular market. In this blog post, we will look at income elasticity and explain how it is calculated, what factors influence it, and how businesses can use this information to their advantage.
Income elasticity of demand | APⓇ Microeconomics | Khan Academy
What does income elasticity of demand measure?
Measured by income elasticity, a product’s demand response to changes in consumer income Demand for a product is more closely correlated with income changes the higher its income elasticity. Businesses use this idea to assess or forecast how changes in the economy might affect their sales.
For instance, a car manufacturer may find that the demand elasticity of income for its mid-range model is positive. The manufacturer then conducts research and discovers that customers’ income will probably increase in the upcoming year. Because the demand for that product typically rises as consumers’ incomes rise, based on its demand elasticity, the manufacturer may decide it’s worthwhile to maintain or increase production of that model. Businesses can use this idea to appropriately price their products. For instance, if they anticipate low demand, they might lower the price of a product to encourage purchases.
What is the income elasticity of demand?
The relationship between demand for a specific good and the income of consumers who buy that good is known as income elasticity of demand. It evaluates how altering one of these influences altering the other. The income elasticity of demand can be calculated using the formula below:
Demand elasticity is determined by the relationship between changes in quantity demanded and changes in consumer income.
How to calculate income elasticity of demand
To determine the income elasticity of demand for a product, follow these three steps as a guide:
1. Identify and calculate the change in consumer income
The percent change in customer income serves as the denominator of the income elasticity of demand ratio. To complete this step, market research or data collection must be done in order to determine current consumer income and income from the previous year. You may use average annual incomes, daily incomes, etc. depending on your circumstances. Subtract the initial income from the current or final income to get the percent change. You then divide that result by the initial income.
For instance, you might discover that the average yearly income of your clients is $55,000 this year as opposed to $45,000 last year. You could perform the following calculations:
Customer income change as a percentage equals (55,000 – 45,000) / 40,000.
Percent change in customer income = 10,000 / 40,000
Percent change in customer income = 0.25 or 25%
2. Identify and calculate the change in demand for a product
The relationship between customer income and a particular good is assessed when calculating income elasticity of demand. Choose the product you want to concentrate on, then conduct data or research to determine how demand has changed during the same time period as the income change you calculated. Similar to the previous calculation, you must subtract the initial demand from the current or final demand and then divide the result by the initial demand to determine the percent change in demand.
Demand can refer to units sold. For instance, you might discover that your company sold 15,000 units this year as opposed to 10,000 units the year before. You could then perform the following calculations:
Demand change as a percentage equals (15,000 – 10,000) / 10,000.
Percent change in product demand = 5,000 / 10,000
Percent change in product demand = 0.5 or 50%
3. Use the income elasticity of demand formula
Put the results of your percent changes in demand and income into the formula for the income elasticity of demand. You must divide the percent change in demand by the percent change in consumer income to arrive at this ratio. Using the previous examples, you can perform the following calculations:
Income elasticity of demand = 0.5 / 0.25
Income elasticity of demand = 2
Types of income elasticity of demand
Depending on the product, income elasticity of demand can change. The results of calculating this concept let you group items into different categories. Businesses can use these categories to comprehend their products and how changes in customer incomes affect them. The types of income elasticity of demand include:
Positive income elasticity of demand
Demand for a good rises as consumer income rises when there is a positive income elasticity of demand. A “normal” good is one with a positive income elasticity of demand. When consumer incomes increase, demand for those everyday goods also increases. There are three types of positive income elasticity:
There are several additional product classifications based on these additional categories. Products that fall into the more expansive category are regarded as “luxury” goods and have a high elastic demand. According to this classification, consumers buy proportionately more of a given product when their income rises, even if it does so only slightly. Likewise, the demand for luxury items falls when income decreases. The items that fall under the less-than-unitary category can be categorized as essential goods. These products show what people buy regardless of income fluctuations.
Zero income elasticity of demand
A situation in which a change in consumer income has no impact on product demand is known as having zero income elasticity of demand. Customers buy the same amount of the product in this scenario whether their income increases or decreases. These goods are considered neutral or essential goods. For instance, a person who owns a car will buy gas regardless of whether their income has increased or decreased. When your calculation yields a result of zero, you can determine that there is no income elasticity of demand.
Negative income elasticity of demand
When a product’s demand is negatively income elastic, it means that demand declines as consumer income rises. It can also happen when a product’s demand rises as consumer spending declines. Inferior goods are those with a negative income elasticity of demand. If the outcome of your calculation is less than zero, you can identify negative income elasticity of demand.
The term “inferior” doesnt refer to the products quality. Instead, it often represents a low-cost substitute for normal goods. As a result, as a customer’s income rises, they purchase the standard good rather than the lesser good. When grocery shopping, someone who recently lost their job might only buy the less expensive store brands. They might go back to the grocery store and buy their preferred name-brand items, like ice cream or cleaning supplies, which are typically more expensive, once they land a new job and their income increases once more.
Example of income elasticity of demand
For more help understanding and figuring out income elasticity of demand, use the example below:
Applebaum Appliances, a local company, wants to determine the income elasticity of demand for its sales of washing machines this year. The economic downturn has resulted in numerous community members losing their jobs. Currently, the average annual consumer income is $45,000, down from $60,000 the year before. 10,000 washing machines were sold this year as opposed to 15,000 the year before. Applebaum Appliances must first determine the percentage change in consumer spending and demand using the calculations below:
Demand change as a percentage equals (10,000 – 15,000) / 15,000, or -33. 33%.
Consumer income change as a percentage equals (45,000 – 60,000) / 60,000, or -25%.
The income elasticity of demand for Applebaum Appliances’ washing machines can be calculated by dividing the percent change in quantity demand (-33 33%) by the percent change in consumer income (-25%):
Income elasticity of demand = -33.33% / -25% = 1.32
Because there are multiple washing machines on the market, Applebaum Appliances concludes that washing machines have a positive and greater than unitary income elasticity of demand. As a result, washing machines could be regarded as luxury items. If the business anticipates increased earnings the following year, it might think about adding more washing machines to its stock to help meet demand.