Income Elasticity

Definition

Income elasticity is a measure of the responsiveness of the quantity demanded of a good or service to a change in the consumer's income. It quantifies the degree to which demand for a product changes when the consumer's income changes, while holding all other factors constant.

5 Must Know Facts For Your Next Test

1. Income elasticity is a key concept in understanding consumer behavior and the impact of changes in income on the demand for different types of goods.
2. The value of income elasticity can range from negative infinity to positive infinity, with the sign and magnitude indicating the type of good and the responsiveness of demand to income changes.
3. Luxury goods have an income elasticity greater than 1, meaning a 1% increase in income leads to more than a 1% increase in the quantity demanded.
4. Necessity goods have an income elasticity between 0 and 1, meaning a 1% increase in income leads to less than a 1% increase in the quantity demanded.
5. Inferior goods have a negative income elasticity, meaning a 1% increase in income leads to a decrease in the quantity demanded.

Review Questions

• Explain how income elasticity of demand is used to classify different types of goods.
  • The value of income elasticity is used to classify goods into three main categories: luxury goods, necessity goods, and inferior goods. Luxury goods have an income elasticity greater than 1, meaning demand for these goods increases more than proportionately as income rises. Necessity goods have an income elasticity between 0 and 1, indicating that demand increases less than proportionately as income rises. Inferior goods have a negative income elasticity, meaning demand for these goods decreases as income increases.
• Describe how income elasticity of demand is related to the concepts of price elasticity of demand and price elasticity of supply.
  • Income elasticity of demand is closely related to the concepts of price elasticity of demand and price elasticity of supply. While price elasticity measures the responsiveness of quantity demanded or supplied to changes in price, income elasticity measures the responsiveness of quantity demanded to changes in income. These three elasticity concepts are all important in understanding consumer behavior and the factors that influence market equilibrium and pricing decisions.
• Analyze how income elasticity of demand can impact a firm's pricing and production decisions in different market conditions.
  • $$\text{The value of income elasticity can have a significant impact on a firm's pricing and production decisions.} \text{For luxury goods with high income elasticity, a rise in consumer income would lead to a more than proportionate increase in demand, allowing firms to charge higher prices and increase production.} \text{In contrast, for necessity goods with low income elasticity, a rise in income would lead to a less than proportionate increase in demand, limiting the firm's ability to raise prices and potentially requiring adjustments to production levels.} \text{For inferior goods with negative income elasticity, a rise in income would decrease demand, forcing firms to lower prices and potentially scale back production.} $$

Related terms

Luxury Goods: Goods for which demand increases more than proportionately as income rises, resulting in an income elasticity greater than 1.

Necessity Goods: Goods for which demand increases less than proportionately as income rises, resulting in an income elasticity between 0 and 1.

Inferior Goods: Goods for which demand decreases as income rises, resulting in a negative income elasticity.