Income Elasticity of Demand - Explained
What is Income Elasticity?
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What is Income Elasticity of Demand?
Income elasticity of demand is an economic concept that measures how demand for a particular good responds to a change in the real income of consumers. It examines the link between real income and demand for goods and how quantity demanded becomes sensitive when there is a change in the real income of people who buy them. Using the income elasticity of demand theory, manufacturers are able to distinguish between products that are germane to consumers and products bought for luxury.
How is Income Elasticity of Demand Used?
How the demand for a particular good change as a result of a change in the real income of consumers is measured using the income elasticity of demand theory. To calculate income elasticity of demand, the ratio or the percentage of change in quantity demanded and the percentage of change in income is estimated. According to income elasticity of demand, the higher the the real income of consumers, the higher their response to the purchase of a particular good. Hence, a change in the real cinome of consumer has effects of the quantity of goods demanded, the effect can however be positive or negative, depending on what the change in real income is.
Calculation of Income Elasticity of Demand
The formula for calculating income elasticity of demand is: Income elasticity of demand = (Percent change in quantity demanded/the percent change in income). Below is an example: Lets assume that a company that manufactures fabric has consumers who demand for a quantity of fabric of 6,000 when their real income was $40,000 but when the real income of the consumers falls to $30,000, the company also experienced a plunge in demand, with the quantity demanded reduced to $2, 500, all other things constant. To get the real value of the income elasticity of demand, the percentage of the income and quantity demanded is estimated. Then, the percent change in quantity demanded is divided by the percent change in income.
Interpretation of Income Elasticity of Demand
Consumers buy goods for two major reasons, whether of necessity or for luxury. Goods purchased based on necessity are normal goods while those purchased for luxury are inferior goods. When there is an increase in the real income of consumers, the quantity of normal goods demanded increase. In the real sense, whether consumers real income increase or not, consumers buy normal goods, hence, normal goods have positive impact on income elasticity of demand. Inferior goods on the other hand result in negative income elasticity of demand, the quantity demanded for goods like this plummet in many cases.
Types of Income Elasticity of Demand
Income elasticity of demand is divided into five, there are five types, they are;
- High income elasticity of demand: which means an increase in real income is more than the increase in quantity of goods demanded.
- Unitary income elasticity of demand: rise in real income and rise in quantity demanded are proportionate.
- Low income elasticity of demand: real income is less than the increase in quantity demanded.
- Zero income elasticity of demand: quantity demanded remains unchanged despite a change in real income.
- Negative income elasticity of demand: There is an increase in real income but a decrease in the quantity of goods demanded.
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- Cross-Price Elasticity of Demand
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- Price Sensitivity
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