Definition: Income elasticity of demand is an economic measurement that shows how consumer demand changes as consumer income levels change. In other words, it shows the relationship between what consumers are willing and able to buy and their income.
What Does Income Elasticity of Demand Mean?
This is an important concept because it shows what consumers and demographics purchase specific products. For example, luxury goods have a positive correlation between income and demand meaning the demand for these products increases as consumer income increases. An example of this might be high-end car.
Inferior goods, on the other hand, have an inverse correlation between income and demand. As income increases, demand for these products decreases. A good example of this is public transportation. As consumers’ income increases, they purchase a car and stop riding the bus.
A normal good has completely constant demand no matter the income level of consumers. For instance, all people purchase bread and milk regardless of their income.
The income elasticity of demand formula is calculated by dividing the change in demand by the change in income.
IED = (percent change quantity in demanded) / (percent change in income)
Let’s look at an example.
Sam works for a jewelry company doing market analysis. They want him to forecast the demand for their products in the next year. Since high-end jewelry is a luxury good, its demand will increase as consumer income increases. Thus, Sam looks at economic reports to see what the job forecast looks like over the next twelve months.
He sees that on average consumer income is set to go up 10 percent in the next twelve months. Based on prior years’ analyzes, Sam knows that high-end jewelry is perfectly elastic. Thus, the change in demand is equal to the change in price.
After going through the calculations, Sam can give a positive report to his boss that consumers should want about 10 percent more jewelry this year than last year.
The elasticity of demand is an important metric to consider how consumers react to income changes in relation to certain goods. It is very important to companies to understand their demand structure, and how demand for their products could change.