Income elasticity of demand – definition
Income elasticity of demand or YED measures how demand for something changes when income rises or falls. It looks at the proportionate change in demand for a product or service in response to changing income levels. Some goods sell relatively better or worse than others when people’s incomes change.
The term ‘sensitivity of demand‘ means the same as ‘income elasticity of demand.’
When GDP is growing, people’s income levels usually rise. GDP stands for Gross Domestic Product. When income levels are rising, goods that are highly-dependent on incomes sell more than those that are not income-dependent.
Bread, milk, and other foods are not income-dependent. Therefore, their sales do not change much when people’s incomes rise.
However, demand for luxury goods, vacations abroad, and gourmet foods rises significantly when incomes increase.
Economics Help says the following regarding the term on its website:
“Income elasticity of demand measures the responsiveness of demand to a change in income.”
“For example, if your income increase by 5% and your demand for mobile phones increased 20% then the YED of mobile phones = 20/5 = 4.0.”
Do confuse the term with price elasticity. Price elasticity is a measure of how a change in price affects demand for something.
Income elasticity of demand – 3 types
There are three classifications for how goods or services respond to changes in income: negative, positive, and neutral (or zero).
Inferior goods have a negative income elasticity of demand.
This means that when incomes rise, demand for those goods declines.
Cheaper cars, for example, are inferior goods. When our income is low, we choose cheaper cars. However, as soon as we can afford it, we go upmarket, i.e., we buy more expensive vehicles.
Normal goods have a positive income elasticity of demand. When incomes go up so does demand for normal goods. In this context, both luxury goods and necessity goods are normal goods.
If income elasticity of demand is greater than 1, it is a luxury good. If, on the other hand, it is less than one (but more than zero), it is a necessity good.
When we go upmarket from cheaper cars because our income has risen, we buy a luxury car. Luxury cars are normal goods.
Staple goods have a zero income elasticity of demand. This means that changes in people’s income have no impact on the sales of those goods.
Salt, ketchup, bread, and milk, for example, are staple goods.
Calculating income elasticity of demand
We calculate income elasticity of demand (YED) as follows:
YED = % change in quantity demanded ÷ % change in income
For example, if people’s income rose by 5% and demand for smartphones increased by 20%, then income elasticity of demand for smartphones would be 4. The calculation would be as follows:
YED = 20 ÷ 5 = 4