Income Elasticity of Demand (YED) is the responsiveness of demand when a consumer’s income changes. It is defined as the ratio of the change in quantity demand over the change in income.
YED is useful for governments and firms to help them decide on what goods to produce and how a change in overall income in the economy affects the demand for their products, i.e., whether it’s inelastic or elastic.
Income Elasticity of Demand can be positive or negative. This depends on the type of good. A normal good has a positive sign, while an inferior good has a negative sign.
For example, if a person experiences a 20% increase in income, the quantity demanded for a good increased by 20%, then the income elasticity of demand would be 20%/20% = 1. This would make it a normal good.
Calculating Types of Income Elasticity of Demand
As mentioned earlier, the formula for calculating the Income Elasticity of Demand is defined as the ratio of the change in quantity demand over the change in income. We can express this as the following:
YED = %∆ in Qd / %∆ in Y = (New Qd – Old Qd)/(Old Qd) / (New Y – Old Y)/(Old Y)
Qd is the quantity demanded and Y represents income.
1. Income Elasticity of Demand for a Normal Good
A normal good has an Income Elasticity of Demand > 0 (Demand for a normal good increases as consumer income increases).
2. Income Elasticity of Demand for an Inferior Good
An inferior good has an Income Elasticity of Demand < 0 (Demand for an inferior good decreases as consumer income decreases).
3. Income Elasticity of Demand for a Luxury Good
Income Elasticity of Demand > 1 are usually luxury goods which are income elastic, which means that consumer demand is more responsiveness to a change in income.
4. Relatively Inelastic Income Elasticity of Demand
0 < Income Elasticity of Demand < 1 are goods that are relatively inelastic, which means that consumer demand rises less proportionately in response to an increase in income.
5. Income Elasticity of Demand is 0
Income Elasticity of Demand = 0 means that the demand for the good isn’t affected by a change in income.
Engel Curves show how demand curves are sloped in response to changes in income. A goods Engel curve reflects its income elasticity and indicates whether the good is an inferior, normal, or luxury good. Engel’s law which states that the poorer a family is, the larger the budget share it spends on nourishment.
Curve 2 – Inferior Goods
The Engel curve has a negative gradient. That means that since the consumer has more income, they will buy less of the inferior good because they can purchase better goods.
Curve 3 – Normal Goods
It has a positive gradient. As income increases, the quantity demanded increases. Amongst normal goods, there are two possibilities. Although the Engel curve remains upward sloping in both cases, it bends toward the Y-axis for necessities (Curve 1) and towards the X-axis for luxury goods.
Uses of Engel Curves
Engel curves are used for equivalence scale calculations and related welfare comparisons, and to determine properties of demand systems such as aggregability and rank.
Engel curves have also been used to study how the changing industrial composition of growing economies are linked to the changes in the composition of household demand.