Question

Explain the main tenants of income elasticity of demand.

Answer 1

In economics, the income elasticity of demand measures the responsiveness of quantity demanded of a good due to change in income of the consumer, keeping everything else constant.

Mathematically, income elasticity of demand (YED)

= (% change in quantity demanded)/(% change in income)

= ∆Qd/∆Y; where Qd = quantity demanded and Y = income of consumer

The value of YED can help can determine the type of the good.

Now, YED can take up different values:

· YED > 1 implies that quantity demanded of the good responds more than proportionately to change in income

· YED = 1 means that quantity demanded of the good responds proportionately to change in income (unitary elastic)

· 0 < YED < 1 implies that quantity demanded of the good responds less than proportionately to change in income

· YED = 0 means that the quantity demanded does not change due to change in income

· YED < 0 implies that the quantity demanded and income are inversely related. Increase in income results in less of the good being demanded and decrease in income results in more of the good being demanded.

The value of YED helps us categorize the type of the good.

If YED is positive, then the goods can be classified as normal goods. This means that when income increases of the consumer, more goods are being demanded at each level of price.

Now, among normal goods, if 0<YED<1, then these normal goods are known as necessities and it implies that the consumer will demand these goods irrespective of changes in level of income. As income rises, the proportion of consumer’s income spent on necessities gradually decline.

Example of necessities are tobacco, water or haircuts.

Now, if YED > 1, then these normal goods are known as luxury goods. Consumers will purchase proportionately more of a luxury good than the increase in income. For example – premium cars or jewellery that are very sensitive to increase or decrease in consumer’s income.

When YED is negative, then we classify these goods as inferior goods which means that increase in consumer’s income results is less of the inferior good being demanded and vice versa. For example – margarine. When the consumer has low levels of income, then he would buy margarine, because it is a cheaper version of butter. But as his income rises, the quantity demanded of margarine declines because he is going to substitute his demand for margarine with butter which has now become affordable for him.