The elasticity of demand measures the changes in quantity demanded to changes in various parameters like the price of the product, income of the consumer, or the price of a competing product or substitute. The elasticity of demand can be classified into three types:
Income elasticity of demand measures the responsiveness of the consumer’s demanded quantity of specific products or multiple products in response to changes in his income level. When there is a change in a consumer’s income level, income elasticity measures how they change their spending patterns among the different products they consume, including changes to their savings bucket. It measures how the changes in a consumer’s real income affect their demand for different products and services.
There are different outcomes when the income elasticity of the consumer is calculated. Demand can go up, stay the same, or even turn negative with the increase in the consumer’s income level. Similarly, when the consumer’s income level declines, the demand can turn negative, stay the same, or even turn positive with the change in the consumer’s income level. The income elasticity of the consumer is used to forecast demand for various products and services with changes in the business cycles.
Income elasticity of demand = percentage change in the quantity demanded of a particular product or a service (Δ Q) / Percentage change in the income level (Δ I).
Income elasticity of demand can be 1, greater than 1 or lesser than 1. If the quantity demanded is Q, the original quantity demanded would be represented by Q 0, and the new quantity demanded after a change in the income will be Q1. Similarly, the original income level is represented by I0, and the changed income level is represented by I1.
The formula for income elasticity can also be represented as ((Q1– Q0)/Q0)/ ((I1-I0)/I0).
A calculated example of income elasticity of demand:
The income elasticity of demand can vary according to the type of the good.
If the income elasticity of demand for a good is greater than 1, then the particular good or service is said to be a luxury good. Whenever the income level rises, as is likely during the upturn of a business cycle or when the consumer shifts to another job with better pay and perquisites, their demand for luxury goods goes up.
Examples of luxury goods include consumer durables, planning a holiday or a cruise abroad, luxury automobiles, jewellery and financial savings products in the form of top-ups and lump sum investments. As the consumer’s income level goes up, the demand for luxury goods increases. The opposite scenario occurs when there is a slump in the economy, and the consumer has to either take pay cuts or is out of a job.
Goods for which the income elasticity is between zero and one are known as necessities. In the case of necessities, when the consumer’s income level goes up, they may consume slightly more, but the increase may not be significant. Necessities include standard grocery products that are consumed every day, like, water, electricity, food, and financial savings products. The goods belong to the industry sector known as defensives.
Inferior goods are those goods in which the income elasticity is less than 0. When the consumer’s income level goes up, the demand for these goods goes down proportionately. For example, a consumer who is consuming margarine or low priced cooking oils like Palmolein oil may switch to a pricier substitute product like butter or sunflower or olive oil. The demand for margarine or Palmolein oil is reduced more than proportionately.
Graphical representation of income elasticity of demand for the different types of goods:
The curved line in the above graph shows that the demand curve,
Interpreting the income elasticity of demand helps classify a good as a luxury, a necessity or an inferior good. Income elasticity is an essential guide to consumer buying behaviour and consequently discerning the pattern of a firm’s investment in a particular industry. It helps analyse consumer budgets and their allocation of resources to various products and services consumed by them. Income elasticity is a vital tool in this context.
Studying and analysing the income elasticity of demand is very important to businesses and firms. It enables them to predict the impact of income pattern changes on demand for products of different industry sectors.
Products are classified as defensive, consumer discretionary and inferior products. All these products have differing income elasticities, which enable businesses to forecast customer buying patterns and analyse the underlying trends. They can study the correlations of business cycles trends with the demand forecasts of their products. When the business cycle is in the boom phase, incomes increase across the spectrum and vice versa during a slump.
Predicting demand patterns based on this correlation between business cycles phases and income elasticity helps businesses plan for the future, prepare their yearly financial budgets and make growth and profit projections.
Various applications of income elasticity of demand are given below:
All human endeavour is undertaken to meet and satisfy our various wants and needs. Our wants and needs drive the demand for various products and services. Knowing our income elasticity helps us classify the products and services into different groups. It enables us to plan our budgets and undertake financial planning better. The underlying connection to trade cycles also helps us anticipate salary and income increases. We also understand better our buying behaviour, that it is based on sound economic principles and is not random or Adhoc. We can undertake better investment decisions when we analyse our income elasticity.
Various factors that drive a consumer’s demand for a particular good or service are the fundamental building blocks of economics. Income elasticity of demand helps calculate the impact of change in income on the demand for a particular good or service. Thus, the importance of the concept of income elasticity of demand in the real world cannot be underestimated.