Income Elasticity of Demand

EdExcel Economics 1.2.3

What is Income Elasticity of Demand?

• The formula for calculating income elasticity of demand (YED) is• % change in quantity demanded / % change in real income• With income elasticity, we distinguish between the following:1. Normal goods – they have a positive income elasticity2. Luxury goods – where the income elasticity > +13. Necessities – here the income elasticity >0 and <+14. Inferior products – these have negative income elasticity• Inferior goods are counter cyclical goods – products whose

demand varies inversely to the macroeconomic cycle – demand rises in a downturn

Income elasticity of demand (YED) shows how responsive the demand for a product is to a change in (real) income

Measures of Income in the UK Economy

2007 Q1

2007 Q2

2007 Q3

2007 Q4

2008 Q1

2008 Q2

2008 Q3

2008 Q4

2009 Q1

2009 Q2

2009 Q3

2009 Q4

2010 Q1

2010 Q2

2010 Q3

2010 Q4

2011 Q1

2011 Q2

2011 Q3

2011 Q4

2012 Q1

2012 Q2

2012 Q3

2012 Q4

2013 Q1

2013 Q2

2013 Q3

2013 Q4

2014 Q1

2014 Q2

2014 Q3

90

92

94

96

98

100

102

104

106

GDP GDP per Capita RHDI Per Capita

Index Numbers, 2008 Quarter 1 = 100

GDP per capita = national GDP / total population = income per headReal household disposable income = income after taxes & benefits and adjusted for inflation

Normal Necessities and Normal Luxuries

When YED is positive, a product is a normal good

• If, following an increase in income, more of the good is demanded, then the good is a ‘normal’ good.

• Normal goods have a positive YED, i.e. YED > 0• Normal necessities: (income inelastic)

– These products have a low but positive income elasticity – typically necessities such as milk and fruits

• Normal luxuries: (income elastic)– These products have a high and positive income elasticity –

typically these are higher-end products considered as a luxury by the relevant group of consumers

• What is considered a necessity and a luxury is contextual – i.e. it depends on the circumstances of the consumers involved

Inferior Goods

Inferior goods have a negative income elasticity of demand

• If, following an increase in income, less of the good is consumed, then the good is an inferior good.

• Such goods have a negative YED, i.e. YED < 0• When real incomes are rising during a period of economic

growth, then the demand for inferior goods will fall causing an inward shift of the demand curve

• When real incomes are falling during a period of recession or (more generally) if wages are rising more slowly than prices, the demand for inferior goods will rise.

• Inferior goods are sometimes called “counter-cyclical” products

Examples of Luxury and Inferior Goods

Knowledge of YED is relevant for a firm, since it can estimate how demand for it’s products will change following a change in incomes

Luxury chocolates Exclusive resorts

Business class travel Fine wines and dining

Own label discounters Urban bus transport

Cigarettes Economy class travel

Household Spending on Tobacco – By Income Decile

Tobacco is widely regarded as an inferior good with negative YED

• Weekly spending on cigarettes is highest for the 4th income decile group.

• There is some evidence that households in the richest 30% of income spend less on tobacco although the effects are not very large.

• The poorest 10% of the population spend more on cigarettes than the richest 10%

• But there is no uniform picture on the link between income and weekly spending on cigarettes.

Average weekly household expenditure on cigarettes in UK in 2013, by gross income decile group (£s)

Lowest ten per cent 2.50Second decile group 2.70

Third decile group 4.00Fourth decile group 4.70

Fifth decile group 4.10Sixth decile group 3.90

Seventh decile group 4.20Eighth decile group 3.80Ninth decile group 2.90

Highest ten per cent 2.30

Income Elasticity of Demand

EdExcel Economics 1.2.3