Income elasticity of demand

Definition Income elasticity of demand is a measure of how much quantity demanded will change when income changes. It is usually referred to as YED.

Formula YED = Percentage change in quantity demanded/percentage change in income

What it means Income elasticity of demand measures responsiveness of quantity demanded to a change in income. This will give a numerical answer, telling us the degree of elasticity. We then refer to a good or service as being income elastic or income inelastic   Income elastic - An income change causes a proportionately bigger change in demand - YED>1 Unitary income elasticity - An income change causes the same proportional change in demand - YED=1 Income elastic - An income change causes a proportionately smaller change in quantity demanded - 0

Normal and inferior goods For most products and services, quantity demanded rises with income - these are called normal goods and they have a positive YED values. EXAMPLE - clothing - as incomes grow, many people replace worn clothes sooner and add to their stock of clothing. If income falls, they buy fewer new clothes. However, some do not behave like this. For inferior goods quantity demanded falls as incomes rises. This is not necessarily a product of poor quality, but it is always seen as less attractive than a more expensive one. EXAMPLE - public transport - as incomes rise many people buy cars and stop using buses

Factors that affect the degree of income elasticity The main determinant of YED is probably whether a product is a luxury or necessity (luxury - income elastic, positive and high YED; necessity - income inelastic, positive and low YED) What classifies as a luxury or necessity varies between individuals. Many things start off as a luxury but become a necessity as they get cheaper. Habits can be slow to change, e.g teabags have a low YED Confidence and expectations have impact on behaviour - if a drop in income is seen as a temporary blip, then spending will be maintained, but a gloomy mood can lead to spending cuts all round.

Real-life examples After the financial crash of 2008-2009, incomes dropped in the UK. This led to a rise in demand for inferior goods, allowing supermarkets such as Aldi and Lidl to take advantage and grow rapidly. Paradoxically, a fall in income had led to a rise in demand, but this can be explained by looking at opportunity costs and the alternatives available. However, sales of tea, which is considered a necessity, continued to rise despite the falls in income, reaching an all-time high in 2010 (they have dropped since due to increasing consumption of coffee - this is an example of changing preferences affecting demand for a product). In the year from the end of 2008 to the end of 2009, median household income in the United Kingdom dropped from, £25,691 to £25,194, a fall of 1.93%. Sales of passenger cars went from 2,131,795 to 1,994,999, a fall of 6.41%. The fact that sales of cars dropped more than income indicates that cars are income elastic, suggesting that buying a new car is a luxury.