CHAPTER 5

THE INCOME ELASTICITY OF DEMAND

What is Income Elasticity of Demand?

Income elasticity of demand measures the relationship between the consumer’s income and the
demand for a certain good. It may be positive or negative, or even non-responsive for a certain product.
The consumer’s income and a product’s demand are directly linked to each other, dissimilar to the price-
demand equation.

- Income elasticity of demand describes the sensitivity to changes in consumer income relative to the
amount of a good that consumers demand. Highly elastic goods will see their quantity demanded
change rapidly with income changes, while inelastic goods will see the same quantity demanded even as
income changes.

The formula for calculating income elasticity of demand is the percent change in quantity demanded
divided by the percent change in income.

If the income elasticity of demand is positive, the good is considered to be a normal good – implying that
when income increases, the quantity demanded at any given price increases.

If the income elasticity of demand is negative, the good is considered to be an inferior good – implying
that when income increases, the quantity demanded at any given price decreases.

If the income elasticity of demand is higher than 1, then the good is considered to be income elastic –
implying that demand rises faster than income. Luxury goods include international vacations or second
homes.

If the income elasticity of demand is higher than 0 but less than 1, then the good is income inelastic –
implying that demand for income-inelastic goods rises but at a slower rate than income.
Income Elasticity of Demand Types

Based on numerical value, the income elasticity of demand is divided into three classes as follows:

1. Positive income elasticity of demand

It refers to a condition in which demand for a commodity rises with a rise in consumer income and
declines with a decline in consumer income. Commodities with positive income elasticity of demand are
normal goods.

There are three forms of positive income elasticity of demand stated as follows:

Unitary – The positive income elasticity of demand will be unitary if the proportionate change in the
amount of a product demanded equals the change in consumer income in due proportion.

More than unitary – The positive income elasticity of demand will be more than unitary if the
proportionate change in the amount of a product demanded is higher than the change in consumer
income in due proportion.

Less than unitary – If the change in the amount of a product demanded in due proportion is less than
the change in consumer income in due proportion, positive income elasticity of demand will be less than
unitary.

2. Negative income elasticity of demand

It refers to a condition in which demand for a commodity decreases with a rise in consumer income and
increases with a fall in consumer income. Inferior goods are such commodities. For example, the
demand for millet will decrease if the income of consumers increases since they will prefer to purchase
wheat instead of millet. Thus, millet is an inferior good to wheat for customers.

3. Zero income elasticity of demand

It corresponds to the situation when there is no impact of rising household income on commodity
production. Such goods are termed essential goods. For example, a high-income consumer and a low-
income consumer will need salt in the same quantity.

Uses of Income Elasticity of Demand

1. Forecasting demand

Forecasting demand applies to the idea that the income elasticity of demand tends to predict demand
for commodities in the future. If there is a substantial change in wages, the change in demand for
products will also be significant. This is because when buyers become aware of a shift in income, they
will change their preferences and expectations for such products.

2. Investment decisions
The idea of national income is very important to businesses as it helps them to decide which sectors
they should invest their money in. In general, investors tend to invest in markets where they can predict
that the demand for commodities is related to a growth in national income or where the income
elasticity of demand is greater than negligible.

CROSS ELASTICITY OF DEMAND

What Is Cross Elasticity of Demand?

The cross elasticity of demand is an economic concept that measures the responsiveness in the quantity
demanded of one good when the price for another good changes. Also called cross-price elasticity of
demand, this measurement is calculated by taking the percentage change in the quantity demanded of
one good and dividing it by the percentage change in the price of the other good.

KEY TAKEAWAYS

The cross elasticity of demand is an economic concept that measures the responsiveness in the quantity
demanded of one good when the price for another good changes.

The cross elasticity of demand for substitute goods is always positive because the demand for one good
increase when the price for the substitute good increases.

Alternatively, the cross elasticity of demand for complementary goods is negative.

Explaining Cross Elasticity of Demand

Substitute Goods

The cross elasticity of demand for substitute goods is always positive because the demand for one good
increase when the price for the substitute good increases.

Complementary Goods

Alternatively, the cross elasticity of demand for complementary goods is negative. As the price for one
item increases, an item closely associated with that item and necessary for its consumption decreases
because the demand for the main good has also dropped.

Usefulness of Cross Elasticity of Demand

Companies utilize the cross elasticity of demand to establish prices to sell their goods. Products with no
substitutes have the ability to be sold at higher prices because there is no cross-elasticity of demand to
consider. However, incremental price changes to goods with substitutes are analyzed to determine the
appropriate level of demand desired and the associated price of the good.

Factors that Influence Demand Elasticity

Below are the factors that exert the greatest influence on the demand elasticity of a product or service.

Type of Good

There are three types of goods: necessity, comfort, and luxury goods.

Necessities are goods needed for basic living such as food and housing. Comfort goods are goods that
make life nicer and happier, such as televisions, organic foods, or a gym membership. Luxury goods
provide added enjoyment and can include a sports car, boat, or an expensive watch. Goods that are a
necessity are typically inelastic, meaning that a change in price is unlikely to impact demand. If the price
of gasoline rises, for example, the demand doesn't change all that much since people need to use their
cars to get to work. Comfort and luxury goods tend to be more elastic because changes in an economic
variable might lead to less consumer demand. It's important to consider a consumer's taste and point of
view since one might consider a product a comfort while another might consider it a luxury. For
example, most people own a car and need it to get to-and-from work each day. However, some people
who can barely afford food or housing might consider a car a luxury.

Price

One factor that can affect demand elasticity of a good or service is its price level. For example, the
change in the price level for a luxury car can cause a substantial change in the quantity demanded. If, for
example, a luxury car maker has an inventory surplus of cars, the company might reduce their prices to
increase demand. If the price is reduced far enough, the car might be affordable to consumers that
couldn't afford the luxury car's original price. Of course, the extent of the price change can determine
whether or not demand for the good changes and if so, by how much.

Income

Also known as the income effect, the income level of a population also influences the demand elasticity
of goods and services. For example, suppose an economy is facing an economic downturn where many
workers have been laid off. The decline in annual incomes for the majority of the population might cause
luxury items to become more elastic. In other words, a recession might cause people to save their
money rather than splurge on luxury items such as flat-screen televisions or expensive watches.

Substitute Availability
If there is a readily available substitute for a good, the substitute makes the demand for the good
elastic. In other words, the alternative product makes the demand for a good or service sensitive to
price changes. For example, let's say the price for Florida oranges increased due to inclement weather or
a bad crop. If California oranges are a close substitute in quality and price, consumer demand for them
will rise.