The income elasticity of demand

The income elasticity is defined as the proportionate change in the quantity demanded resulting from a
proportionate change in income. Symbolically we may write

The income elasticity is positive for normal goods. Some writers have used income elasticity in order to
classify goods into ‘luxuries’ and ‘necessities’. A commodity is considered to be a ‘luxury’ if its income
elasticity is greater than unity. A commodity is a ‘necessity’ if its income elasticity is small (less than unity,
usually).

Some Important Income Elasticity:

We have seen that in the price elasticity of demand, elasticity equal to one was very important as it made the
division between elastic and inelastic demands. But, in the case of income elasticity of demand, there is no
unique dividing line. It is not easy to say at once as to what are the most important values of income
elasticity.

However, the following income elasticities of demand seem to be interesting, which show that an
understanding of the income elasticity of demand useful both for business firms as well as the Government.

First, zero income elasticity is of great significance. It implies that demand for commodity does not change
with the change in income. In this case, consumer does not spend anything on the commodity out of the
increase in his level of income.

Consequently, consumer’s expenditure on the commodity under consideration does not increase with the
increase in his income. Zero income elasticity in this way becomes a dividing line. On one side of this line are
the goods, whose income elasticity is positive. With the increase in income, more quantity of such goods is
bought.

This is the case with most of the goods (normal goods). On the other side of this line are the goods whose
income elasticity is negative. It means that with the increase in the income, consumer spends less on these
goods. In other words, increase in income leads to a fall in the quantity purchased of these goods.

How much fall in the quantity purchased will be, depends upon the numerical value of the income elasticity.
These goods are called inferior goods, because, with the increase in the income, consumer does not like to
consume these goods. Instead, he purchases some better goods whose income elasticity is positive.
Second important value of income elasticity of demand is one. In this case, demand for a good rises in
proportion to rise in income. This means that consumer continues to spend the same proportion of his
income on the good under consideration, as he was spending before the rise in income.

If the elasticity of demand is greater than one, it means that he spends a larger proportion of the increase in
income on the good than he was spending before the rise in income. And if the income elasticity of demand
is less than one, it means that he spends a smaller proportion of the increase in income than he was
spending before the increase in income.

One can think that if after the increase in income, consumer spends a larger proportion on a good (ey > 1), it
should be a superior good or a luxury. On the other hand, if proportion of the consumer’s income spent on a
good falls (ey < 1), it is a necessity or an inferior good.

In first case, demand for commodity rises more than in proportion to a rise in income, while in the second
case demand for commodity rises less than in proportion to a rise in income, resulting in concave and convex
shaped Engel curves respectively.

Income elasticity exceeding one implies that the sales of the product will rise more rapidly than economic
growth. Likewise, income elasticity lowers than one implies that the sales of the product will rise, but, slower
than the economic growth. If the economy is growing at 5% and income elasticity of demand is 0.2, a firm in
the industry can expect annual sales rise of 5% x 0.2 = 1%.

Similarly, if income elasticity is 2, firms can expect sales to grow at the rate of 5% x 2= 10% annually. In the
former case, the product of the firm lags economic growth, while, in the latter case, the product leads to
economic growth.

Firm with product having high income elasticities have good growth opportunities in the expanding
economy. This poses a serious problem for the policy makers of most of the developing economies plagued
by this disease. Whether the product will lag or lead economic growth can be known from the value of
elasticity of demand of the product.

Similarly, in times of recession, decline in the sales of the firm will be slower or faster than the decline in
economic activity, depending on whether income elasticity is less than one or exceeds one in the two cases
respectively. Firms whose products have low income elasticities neither gain much, if the economy neither
expands nor lose much, if the economy retards.

On the other hand, firms having product with high income elasticities indicate susceptibility to fluctuations in
economic activities. Thus, the knowledge of income elasticities is useful in forecasting the effects of changes
in economic activity on demand and hence in planning the product mix by the business firms.
Now, it can be concluded that income elasticity of demand is different for different goods Luxuries like cars,
jeweller’, precious stones, etc. have high elasticity. While necessities like vanaspati ghee, soap, salt, matches,
etc. have low elasticity. By and large, income elasticity is higher for durable goods than for non-durable
goods.

The main determinants of income elasticity are:

1. The nature of the need that the commodity covers the percentage of income spent on food declines as
income increases (this is known as Engel’s Law and has sometimes been used as a measure of welfare and of
the development stage of an economy).

2. The initial level of income of a country. For example, a TV set is a luxury in an underdeveloped, poor
country while it is a ‘necessity’ in a country with high per capita income.

3. The time period, because consumption patterns adjust with a time-lag to changes in income.

The cross-elasticity of demand:

It is measured as the ratio of percentage change in amount demanded of one commodity to the percentage
change in price of other commodity. Let the quantity demanded of commodity ‘X’ depends upon the price of
commodity ‘Y’ Cross elasticity of demand (e c) between ‘X’ and ‘Y’ is:
The sign of the cross-elasticity is negative if x and y are complementary goods, and positive if x and y are
substitutes. The higher the value of the cross-elasticity the stronger will be the degree of substitutability or
complementarity of x and y. The main determinant of the cross-elasticity is the nature of the commodities
relative to their uses. If two commodities can satisfy equally well the same need, the cross- elasticity is high,
and vice versa. The cross-elasticity has been used for the definition of the firms which form an industry.

The main determinant of cross elasticity of demand is the nature of the commodities relative to their uses.
The cross elasticity is high, when the two commodities satisfying the same need equally well and vice-versa.

The knowledge of cross elasticity is important for business firms operating in markets with different brands
competing with each other. Such information helps them to find the effects of change in price of one brand
on the others supplied by the competitors. If the cross elasticity of demand between two rival products ‘A’
and ‘B’ is 2, the firm of product ‘A’ can expect 20 percent rise in demand for its product with every 10 per
cent rise in the price of product ‘B’.

Thus, cross elasticities play a vital role under monopolistic competition and oligopoly in taking price, output
and product decisions, so as to avoid potential loss from rivals’ strategies. Further, by keeping the cross
elasticities between its product and other similar ones, firm can prove that substitutes are close and buyers
have effective choice. This will protect it from anti-trust laws.