Income Elasticity of Demand: Definition, Formula & Example

Instructor: Toni Bonton

Toni has taught personal finance and is currently pursuing a doctorate in business administration.

How customers spend money is a direct reflection of their income. A higher income allows the consumer to spend more, while the opposite is true for a lower income. This lesson breaks down the income elasticity of demand.

Money Talks

Elliott is a college student. Because he has a limited income, Elliott budgets his money very carefully. Part of Elliott's budgeting means he only buys store-brand foods because they are less expensive than premium brand foods. It also means that Elliott cannot afford to make very many unnecessary purchases, like the new gaming console he has been eyeing.

Kerry, on the other hand, just graduated college and now has a high-paying job at a large engineering firm. Kerry is also careful to budget her money; however, she enjoys buying premium brand foods, even though they are more expensive. She even gets to do a little more traveling with her extra income. Elliott and Kerry's spending behavior is the foundation of the income elasticity of demand.

Cha-ching!

The income elasticity of demand is a measurement that explains how the demand for a good or service changes when income changes. Simply put, when a consumer has a change in income, it affects the amount of money the consumer is able to spend on a good or service. If the good or service is essential, e.g. food, clothing, shelter, the consumer is bound to purchase that good or service; however, income will still have an impact on the purchase.

Let's go back to Elliott and Kerry.

Elliott and Kerry both head to the local grocery store to buy cheese. Elliott opts for the Save-A-Buck brand of cheese at $1.99, but Kerry chooses the Fine & Fancy brand of cheese at $3.99. Elliott and Kerry both have to buy cheese, but because Elliott has a lower income than Kerry, he cannot afford to spend as much money as Kerry is able to spend on cheese.

A lower income means the demand for generic brands will increase while the demand for premium brands will decrease; on the other hand, a higher income means the demand for premium brands will increase while the demand for generic brands will decrease. The bottom line is that the demand for a good or service will increase or decrease based on the consumer's income. Let's use an increase in income to see what the income elasticity of demand looks like on a graph.

IED_down

Here an increase in income (I) means a decrease in the demand (Qx) for generic products and services. Since Kerry has seen an increase in her income, there is a decrease in her demand for Save-A-Buck cheese.

IED_up

Here an increase in income means an increase in the demand for premium brands. Kerry's increase in income means there is an increase in her demand for Fine & Fancy cheese.

The income elasticity of demand also works for nonessential, or luxury, purchases. Since the purchase is not a necessity, the consumer does not need the good or service; therefore, the consumer's income will determine whether or not the consumer actually makes the purchase.

Let's look at Elliott and Kerry once again. Elliott and Kerry both enjoy watching movies. Elliott's budget for entertainment is small, so he likes to rent movies from BlueCrate, a movie kiosk near his apartment complex. Kerry, however, goes to the theater every weekend to watch a movie. Take a look at what happens to the demand for luxury purchases when income increases.

IED_down

When income increases, the demand for movie rentals decrease.

IED_up

When income increases, the demand for movie tickets increase.

Let's Talk Numbers

The change in the demand divided by the change in income reveals the income elasticity of demand.

IED_formula

The income elasticity of demand represents the impact income has on the demand for a good or service. If the income elasticity of demand is less than 1.00, the good or service is said to be inelastic to income, meaning the impact of income is weak. If the income elasticity of demand is more than 1.00, the good or service is elastic to income, meaning the impact of income is strong. Think of the good or service as a rubber band and the only thing that can stretch that rubber band is income. When the good or service is inelastic, the impact of income is present, but not enough to stretch the rubber band. An elastic good or service means the impact of income is strong enough to stretch the rubber band.

Let's break that down some more!

The demand for cheese has increased by 5% due to a 10% increase in income.

5% (the change in demand) / 10% (the change in income)

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