Chapter 3.4: Income Elasticity of Demand – Fail Proof Summary 100% Pass IB Exams

Click here to learn more about the concept of income elasticity of demand, its formula, determinants and varying types with ready examples!

Income Elasticity of Demand

Income Elasticity of Demand is the numerical measure of the responsiveness of the quantity demanded following a change in income.

Formula

The formula can be abbreviated into:

Simplifying the above formula can be rewritten as:

The Sign of YED (+ / -)

Income Elasticity of Demand provides two kinds of information:

the sign of YED: positive or negative
the numerical value of YED: whether it is greater or smaller than one (assuming it is positive)

Unlike Price Elasticity of Demand (PED) and Price Elasticity of Supply (PES), we must consider the sign when interpreting Income Elasticity of Demand (YED), besides the value, whether it is more or less than 0 and 1.

Sign of Income Elasticity of Demand: Normal or Inferior Goods

YED > 0 = a positive income elasticity of demand means that the good is normal.

Normal good is a good that experiences an increase in demand because of an increase in consumer’s income.

For example, hamburgers and consumer cars.

As Income (Y) increases, Quantity demanded (Qd) increases.

YED < 0 = a negative income elasticity of demand means that the good is inferior.

Inferior good is a good that experiences a decrease in demand because of an increase in consumer’s income.

For example, used clothes and second hand cars.

As Income (Y) increases, Quantity demanded (Qd) decreases.

Numerical Value of Income Elasticity of Demand: Necessities, Luxuries, and Services

YED < 1 = Necessities. If a good has a YED that is positive but less than one, it has income inelastic demand.

Income inelastic demand = a percentage increase in income produces a smaller percentage increases in quantity demanded. Necessities are income inelastic goods.

For example:
In developed countries, YED for food is about 0.15 to 0.2. This means that a 1% increase in income produces 0.15% to 0.2% increase in spending on food; or a 10% increase in income results in a 1.5% to 2% increase in spending on food.

YED > 1 = Luxuries and services. If a good has a YED that is greater than one, it has income elastic demand.

Income elastic demand = a percentage increase in income produces a larger percentage increase in quantity demanded. Luxuries and services are income elastic goods.

For example:
jewellery, expensive cars, private education, eating in restaurants.

Example Question

Question 1

	Original Demand (per period of time)	New Demand
Product A	100 units at the current price ($10)	103 units at the same price ($10)
Product B	100 units at the current price ($10)	99 units at the same price ($10)
Product C	100 units at the current price ($10)	101 units at the same price ($10)

YED of A:

Since YED is positive, we can say that it is a normal good and that is has an elastic demand as the value is greater than 1.

YED of B:

Since YED is negative, we can say that it is an inferior good and that is has an inelastic demand because the value is less than 1.

YED of C:

Since YED is positive, we can say that it is a normal good and that is has an inelastic demand because the value is less than 1.

Question 2

Suppose person A’s income increases from $800 per month to $1000 per month, and her purchases of clothes increase from $100 to $140 per month. What is her income elasticity of demand for clothes?

income elasticity of demand example question

So, income elasticity of demand for clothes is +1.6.

Question 3

If we know YED and the percentage change in quantity demanded, it is simple to calculate the percentage change in income. Suppose YED = 0.75 and quantity demanded of a normal good has increased 15%. The percentage change in income is found by taking

Income increased by 20%.

Question 4

Similarly, if we know YED and the percentage change in income, we can calculate the percentage change in quantity demanded. Suppose YED = 1.25 and income increases by 20%. The percentage change in Q is found by:

Quantity demanded increased by 25%.

Whether a Good is a Necessity or Luxury Depends on Level of Income

For people with extremely low incomes, even food and certainly clothing can be luxuries.

For example, items like Coca-Cola and coffee for many poor people in less developed countries are luxuries, whereas for consumers in developed countries they have become necessities.

For an increase in income of 10%, spending on food increases by only 1.5% – 2% in rich countries and by 8% in poor countries.

Determinants of Income Elasticity of Demand

Determinant	Income Elasticity
Nature of The Good	– Luxuries: YED > 1 – Normal Goods: YED > 0 – Very Basic Necessities: YED = 0 – Inferior Goods: YED < 0
Duration of Income Change	– Short run: Income Inelastic Demand – Long run: Income Elastic Demand
Cultural and Societal Factors	– Saving culture: Income Inelastic Demand – Spending culture: Income Elastic Demand
Economic Environment	– Economic Pessimism: Income Inelastic Demand – Economic Optimism: Income Elastic Demand
Availability of Substitutes	– Limited Availability: Income Inelastic Demand – High Availability: Income Elastic Demand
Future Expectations	– Negative Expectations: Income Inelastic Demand – Positive Expectations: Income Elastic Demand
Depth of Market Research	– Limited Market Understanding: Income Inelastic Demand – Extensive Market Understanding: Income Elastic Demand

Demand Curves and YED

Since income is a non-price determinant of demand, we can illustrate the changes in income elasticity of demand (YED) using a leftward or rightward shift in the demand curve.

Note: For necessities, an increase in income will lead to a relatively small rightward shift in the demand curve. For luxuries and services, the rightward shift will be larger.

Engel Curve

The Engel Curve is another way of illustrating income elasticity of demand (YED) than demand curve shifts. Its name comes from Ernst Engel, a German statistician and economist who lived in the 19th century, and who was the first to study the relationship between consumer income and demand for a product.

Explanation

From point A to C, hot dogs are a normal good since the increase in income from $100 to $250 causes quantity demanded to increase from 4 hot dogs and 9 hot dogs. As income increases further to $350 the quantity remains constant at 9 hot dogs, but as income increases even more the quantity falls from 9 to 8 hot dogs (e.g. consumers decide to switch to other substitutes after having more money to spend for food). Afterwards, when income rises above $350, hot dogs become an inferior good for this consumer (they are more able to afford something more expensive for food).

The Engel Curve shows that at very low incomes a good may be a luxury; as income increases it becomes a necessity and finally at high income levels it becomes inferior.

Applications of Income Elasticity of Demand (HL Only)

YED and Producers: The Rate of Expansion of Industries

As countries experience economic growth, society’s income increases. Increasing income means a growing demand for goods and services. Suppose that total income in an economy grows at an average rate of about 3% per year.

If goods and services have income elastic demand (e.g. restaurants, movies, foreign travel etc), this means that demand for these goods and services grows at a higher rate than 3%. This group of products will automatically grow and expand faster than the country’s total income.

Other goods and services with income inelastic demand (food, clothing, furniture) will have a rate of demand that grows lower than 3%. This group of products will consequently grow and expand slower than the country’s total income.

So, to conclude, the higher the YED for a good or a service, the greater the expansion of its market is likely to be in the long run; the lower the YED, the smaller the expansion.

However, the impact of YED on an economy may be different if we were to say that the country is experiencing a recession (falling output and incomes). The type of products with income elastic demand (YED > 1) will experience a large decline in sales.

On the other hand, products with low YEDs (YED < 1) can avoid large falls in sales, while inferior goods (YED < 0) may even experience an increase in sales.

YED and The Sectoral Structure of The Economy

Every economy has 3 main sectors: primary (agriculture, forestry, fishing, and extractive industries), secondary sector (manufacturing) and tertiary sector (services such as travel, banking, insurance, education, and healthcare). With increasing economic growth, the relative size of 3 sectors usually change over time and these changes can be explained in terms of income elasticity of demand.

Agriculture, the primary sector’s biggest contributor, generates food which is a product with a positive but YED < 1 (income inelastic). As society’s income rises, so does the demand for agricultural production. However, the demand for agricultural output grows slower than income growth. Other core products with low income elasticity of demand, such as cotton and rubber, have synthetic substitutes. So, often, as income increases, more is spent on its synthetic substitutes rather than cotton and rubber. Manufactured goods, such as cars, televisions, and computers, YED > 1, indicating that as society’s wealth increases, so does the demand for these goods. Many services have even greater YEDs, resulting in a larger percentage rise in demand.

Therefore, over time, the share of agricultural output in total output in the economy shrinks, while the share of manufactured output grows. Since the service sector has a high income elastic demand (as demand for its type of products increases faster than the increase in income), it may even expand greater than the manufacturing and primary sectors as the economy continues growing.

changing relative shares in 3 main economic sectors due to income elasticity of demand

Simple Review Questions

Define the term ‘Income Elasticity of Demand’ and explain how it can be used by businesses to predict changes in demand for their products during economic fluctuations.
Differentiate between normal goods and inferior goods in the context of Income Elasticity of Demand. How might businesses adjust their strategies based on the YED of their products?
Your income increases from $1000 a month to $1200 a month. As a result, you increase your purchases of pizzas from 8 to 12 per month, and you decreases your purchases of cheese sandwiches from 15 to 10 per month.
a) Calculate income elasticity of demand for pizzas and cheese sandwiches
b) what kind of goods are pizzas and cheese sandwiches?
c) show using demand curve shift diagrams the effects of your increase in income on your demand for pizzas and cheese sandwiches
A 15% increase in income leads to a 10% increase in demand for good A and 20% increase in demand for good B.
a) Identify which of the two goods is income elastic and which is income inelastic
b) Identify which of the two goods is likely to be a necessity and a luxury
Using the information and example of Engel Curve, calculate YED for an increase in income:
a) from $100 to $150
b) $150 to $250
c) $250 to $350
d) $350 to $450
e) Explain what your results for these YEDs tell you about the nature of the good for the various income levels