Income Elasticity of Demand

Income Elasticity of Demand

The responsiveness of quantity demanded to a given change in real income

Income Elasticity of Demand equation

YED = (%∆Qd)/(%∆Y) = (ΔQd/Qd)/(ΔY/Y)
Unlike PED, YED can be negative or positive and the sign matters!

If YED +ve (e.g. 0.5, 2)

Quantity demanded increases as real income rises. Normal goods.
Increases in income lead to a rightward shift in demand

If YED +ve and >1 (e.g. 1.5, 5)

Quantity demanded increases by proportionately more than the rise in real income
Luxury goods aka Superior Goods.
So as incomes rise, the proportion of a consumer's income spent on that product will go up

If YED +ve and <1 (e.g. 0.1, 0.8)

Quantity demanded increases by proportionately less than the rise in real income
Necessity goods.
As income rises, the share or proportion of their budget on these products will fall

If YED -ve (e.g. -0.75, -4)

Quantity demanded decreases as real income rises. Inferior good.
Increase in income lead to a leftward shift in demand

Factors determining YED

1. Whether the nature of the good is a necessity or a luxury
2. The level of income of a consumer

1. Whether the nature of the good is a necessity or a luxury

When people's incomes rise they will spend more on all normal goods (they have positive YED coefficients).
But increases in income will have see consumers spend more on luxurious goods to treat themselves - high YED.
At the same time, they will likely have satiated their demand for necessities and so will not increase their consumption of them that much - low YED.
E.g. If your income were to double, your expenditure on food would likely rise a little bit, but your expenditure on items such as foreign holidays would likely rise considerably
Examples
luxury - fine wines
necessity - vegetabkles
inferior - processed vegetables

2. The level of income of a consumer

If a good represents a large proportion of a consumer's income it will have a higher YED
A good that is a YED necessity to most consumers might be a YED luxury to the poorest in society, and so when incomes rise by a given amount the proportional changes in quantity supplied will differ.
E.g. If a Middle-class family saw their income rise by 10% they might buy 5% more meat (low YED), but if a poor households income rose by 10% they might spend 50% more on meat (high YED).
At the same time, a good that is a YED luxury for most consumers might have a lower YED value for higher income consumers as they will seek out more luxurious goods.
E.g. If my income doubled I might buy a car, but if Jeff Bezos' income doubled he won't buy many more cars, but might buy a yacht.

Relevance of YED to Firms

Key Point: Firms need to know what the YED of their product is for their market in order to make preparations for the future.

Standards of living
The economic cycle

Standards of living

As global standards of living increase we would expect to see an increase in demand for luxury goods and a movement away from inferior goods.
Wealthier countries are likely to have consumers with higher disposable incomes
This means that they have greater spending power and are likely to use some of this greater income to buy luxury goods and services.
Therefore, firms in these countries will produce superior products that meet the needs of these consumers e.g. high technology goods and complex financial services.

The economic cycle

Firms will identify the state of the economy e.g. recession and produce goods and services to meet the demand of consumers.
When the economy is in recovery mode and leading into boom disposable incomes increase and consumers spend a greater proportion of this increase in income firstly on necessities and then on luxury goods.
When the economy is in decline and leading into slump disposable incomes decrease and consumers spend a lesser proportion of their incomes on luxury goods, moving to necessities and then inferior goods.
For example: Pound shops selling necessities and inferior goods are likely to expand in these market conditions.