Definition and measurement of income elasticity of demand

Income elasticity of demand is the responsiveness of quantity demanded to a change in household income. It is measured by the equation:

% change in Qd / % change income = YED

For example, if a 5 per cent increase in household income leads to a 7 per cent increase in quantity demanded for computer game consoles such as the Sony PlayStation the YED would be:

+7% QD / +5% Y = +1.4

This means that for every 1 per cent increase in household income the quantity demanded of games consoles will increase by 1.4 per cent. This relationship is shown in diagram 2.24 where a rise in income causes the demand curve for game consoles to increase and shift to the right.

Interpretation of income elasticity of demand

Normal goods

Normal goods have a positive YED. Quantity demanded rises as income rises, and quantity demand falls as income falls. The +1.4 YED value for computer games consoles shows they are normal goods. Most goods are normal because as incomes rise people will demand more of most goods, but the rate of increase will be different for different types of goods.

Necessity goods

Necessity goods are normal goods that have a YED between 0 and 1. For example, if there is a 5 per cent rise in household incomes and the quantity demanded for electricity increases by 1 per cent.

+1% QD / + 5% Y = +0.2 YED

The demand for necessity goods such as basic food, energy and public transport will have YED values between 0 and 1.

Luxury goods

Luxury goods are normal goods and the demand for them has a YED of greater than 1. This means a rise in income will lead to a greater than proportionate increase in quantity demanded, and a fall in income will lead to a greater than proportionate fall in quantity demanded. If, for example, the quantity demanded for 5-star hotels increases by 8 per cent following a 6 per cent rise in incomes then the YED would be:

+8% QD / +6%P = +1.33

This YED value means the quantity demanded for 5-star hotels increases by a more than proportionate amount relative to the change in income. Luxury goods such as prestige cars, designer clothing and exclusive restaurants will have YED values of greater than 1.

Inferior goods

The demand for inferior goods will have a negative YED because the quantity demanded for inferior goods falls as household incomes rise and rise as incomes fall.

For example, the quantity demanded of dried packet soup falls by 3 per cent following a 4 per cent rise in household income. This is calculated as: -3% QD / +4% Y = -0.75.

Inferior goods such as tinned food, bus travel and synthetic clothing will often have negative YEDs. Although this will vary between countries.

The chart summarises the YEDs of inferior, necessity and luxury goods.

Engel Curve (HL)

The nineteenth-century German economist, Ernst Engel studied how the demand for different goods and services changed with income over time. The Engel Curve relationship between income and demand is shown in diagram 2.24(1).  In this example, the diagram shows how the demand for rice changes with income over time.

When income increases for poorer households the demand for rice increases as rice is considered a normal or luxury good by households on low incomes. Beyond point A, households are on middle incomes where rice becomes a necessity good to these consumers. This means that any increase in income beyond A leads to a less than proportionate increase in the demand for rice.

Once household incomes rise above point B any increase in income will lead to a fall in demand for rice because it is now considered an inferior good by the consumer. Above income level B, households will not demand as much rice and switch to luxury good alternatives. Individuals might substitute rice-based meals for meat-based meals.

The Engel curve is useful in showing how the income elasticity of different goods changes over time. For example, the demand for goods such as smartphones would have been luxury goods when they were first launched with a YED of greater than one, but their YED falls as smartphones become a more established product amongst consumers. Very basic smartphones can become inferior goods over time. 

The Engel curve is useful in showing how the income elasticity of different goods changes over time. For example, the demand for goods such as smartphones would have been luxury goods when they were first launched with a YED of greater than one, but their YED falls as smartphones become a more established product amongst consumers. Very basic smartphones can become inferior goods over time. 

Application of income elasticity of demand (HL)

Structural changes in the economy

YED data can be used to show how industrial structure changes in the economy over time, as household incomes rise when the economy grows. The YED for primary goods or commodities, which are often considered necessities, tend to have a YED of between 0 and 1. This means the demand for commodities tends not to grow as incomes rise in the economy over time. An economy that specialises in primary commodities, as some developing countries do, will experience slow growth as the world incomes rise.

Manufactured goods such as cars and computers have greater positive YED values because consumers are more likely to buy this type of good as their income increases. When incomes increase over time, these industries may experience significant growth. Policymakers often see the development of manufacturing in developing countries as an effective way to deliver economic growth as world incomes rise. 

The service sector of an economy such as tourism and leisure tends to have the highest positive YED values. YED can be used to explain why the industrial structure of many economies is increasingly dominated by the service sector as household incomes rise.

Business strategy

Businesses respond to income changes by adapting what they sell.  As incomes have generally increased over time in most economies, many firms have responded by improving the quality of the products they sell because the demand for these goods has a positive YED value.  Ice cream brands like Haagen Das and Ben and Jerry's, have marketed their luxury good ice cream brands in response to rising incomes. In economic recessions when household incomes tend to fall, businesses that market inferior goods can see the demand for their goods rise as consumers switch to lower-priced inferior goods. Food producers, for example, might plan to increase the output of products that are inferior such as tinned, dried and frozen food.