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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Income Elasticity of Demand

What it is:

Income elasticity of demand is a measure of how much demand for a good/service changes relative to a change in income, with all other factors remaining the same.

How it works (Example):

The formula for income elasticity is:

Income Elasticity = (% change in quantity demanded) / (% change in income)

An example of a product with positive income elasticity could be Ferraris. Let's say the economy is booming and everyone's income rises by 400%. Because people have extra money, the quantity of Ferraris demanded increases by 15%.

We can use the formula to figure out the income elasticity for this Italian sports car:

Income Elasticity = 15% / 400% = 0.0375

An example of a good with negative income elasticity could be cheap shoes. Let's again assume the economy is doing well and everyone's income rises by 30%. Because people have extra money and can afford nicer shoes, the quantity of cheap shoes demanded decreases by 10%.

The income elasticity of cheap shoes is:

Income Elasticity = -10% / 30% = -0.33

Why it Matters:

As an economy grows and expands, people will enjoy a rising income. In most cases, the demand for goods and services is likely to increase as well.

As incomes rise, demand for income elastic goods/services will increase because people will have more money to spend. Income elastic goods include luxuries like airline travel, movies, restaurant meals and automobiles.

As income rises, demand for income inelastic goods/services tends to increase only marginally. Consumer staples like toothpaste and "sin" items like tobacco and alcohol tend to fall into this category.

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Finally, a good/service with negative income elasticity is known as an inferior good. In many parts of the world, bicycles are an inferior good. As income rises, demand for bicycles decreases as people trade up to cars.

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