Income Elasticity of Demand in Microeconomics

Income Elasticity of Demand in Microeconomics
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  • 0:04 Income Elasticity of Demand
  • 0:44 Normal Goods
  • 2:12 Necessities
  • 3:00 Inferior Goods
  • 4:05 Lesson Summary
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Lesson Transcript
Instructor: James Walsh

M.B.A. Veteran Business and Economics teacher at a number of community colleges and in the for profit sector.

The income elasticity of demand is a useful tool that measures what happens to consumer demand for products and services when incomes change. We will work through the formula and interpret what the answers mean.

Income Elasticity of Demand

Any Town is just your typical city located in a flyover state. The town received some good news about a year ago when a food processor built a big plant on the outskirts of town. What that meant for the citizens was jobs and more income. Now lots of people who used to work for minimum wage are making boxes of cereal and bags of frozen veggies at the plant for a lot more money. With more money in their pockets, the citizens have changed their spending habits. We can measure that with the income elasticity of demand, which shows us the sensitivity of changes in income on quantity demanded for products and services.

Normal Goods

No one has been happier about the new food plant than the car dealerships of Any Town. The old clunkers that used to slow down traffic in Any Town have been replaced by shiny new vehicles. Let's calculate the income elasticity for new cars in Any Town. Here's the formula:

Income Elasticity = Percent Change in Quantity Demanded / Percent Change in Income

New vehicle sales (quantity demanded) went from 5,000 per year to 7,000 per year, an increase of 2,000 / 5,000 = 40%. Average income in Any Town went from $40,000 per year to $50,000 per year. That's an increase of 10,000 / 40,000 = 25%. So the income elasticity is 40% / 25% = 1.6. This means that income elasticity is greater than 1.

If income increases by a certain percent, quantity demanded for the product will increase by a greater percent than the income increase. That's the definition of a normal good. Most of the consumer goods we buy, like electronics and clothing, are normal goods. We buy more of them and better quality when our income increases. Remember, though, that it goes the opposite during hard times. When incomes decline, spending on normal goods will fall even faster than the decline in income.

Necessities

The grocers of Any Town have noticed a difference too. Shoppers are in better moods with more money in their pockets but, surprisingly, sales haven't gone up much. People are split on this. Some spend more on expensive food, like steaks, but others spend less in the grocery store since they're eating out more.

The income elasticity formula for the 3% increase in food sales looks like this: 3% / 25% = 0.12. Any time the income elasticity is between 0 and 1.0, the item is a necessity. The quantity demanded for necessities doesn't change much even when income does. People will spend just about as much regardless. Electric and gas utilities are another example of necessities.

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