INCOME ELASTICITY OF DEMAND

The income elasticity of demand measures the responsiveness of sales to changes in income, ceteris paribus. It is defined as the percentage change in sales divided by the corresponding percentage change in income. The methods used to calculate arc income elasticity (EI) and point income elasticity (eI) are as follows:

income-elasticity-1Given information on sales and income, the calculation of income elasticities is strictly analogous to the calculation of price elasticities. If the income elasticity of demand for a product is greater than one, the product is said to be income elastic; if it is less than one, the product is income inelastic. For normal goods, the income elasticity is greater than 0 because with rising incomes, consumers will purchase a greater quantity of such goods, ceteris paribus. If the income elasticity for a commodity is negative, the good is an inferior good; that is, people will choose to purchase lessincome-elasticity-feature-1 of the product when their income increases. Potatoes may represent examples of inferior goods for some households, as would purchases from the cheap stores. The reason is that some households consume certain goods only because of lack of purchasing power. As income increases it is possible the household will shift away from the purchase of these inferior goods. Income elasticity relationships can be summarized as follows:

Normal goods are indicated by eI or EI > 0. Inferior goods are indicated by eI or EI < 0.

If eI or EI > 1, the good is income elastic.

If eI or EI < 1, the good is income inelastic.

If eI or EI = 1, the good is unitarily income elastic.

To illustrate just one way in which income elasticity may be useful, consider the following situation. A firm has obtained a fairly reliable estimate of the projected percentage increase in income for its market area for the next year; let’s say 4.5 per cent. Managers know that sales are currently running at an annual rate of 200,000 units, and the marketing analysis group has estimated the arc income elasticity of demand for the product at 1.2. If other factors are expected to remain relatively constant, we can use this information as one input into projecting sales for the next year, as follows:

income-elasticity-2

Thus, next year’s sales would be projected to be 5.4 per cent above the current level, or 1.054 times this year’s sales:

(1.054)(200,000) = 210,800 units.

Knowledge of income elasticities is also useful at different stages of a business cycle. For example, during periods of expansion, firms selling luxury products such as exotic vacations or big cars find demand for their products will increase at a rate that is faster than the rate of growth of incomes. However, during an economic recession demand may decrease rapidly for such products. Conversely, sellers of necessities such as basic food will not profit much during periods of economic prosperity, but will also find that their products are recession proof.

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