Let’s say you’re a coffee enthusiast who treats yourself to a steaming cup of Starbucks coffee every morning before work. Now, you’ve just landed a promotion, resulting in a significant income rise, and you are treating yourself to those rich brews twice a day.
This change in your coffee consumption patterns is due to the income elasticity of demand - a concept that tracks how changes in your income change your demand for various goods and services.
Income elasticity of demand measures the changes in the customer’s demand for any good or service with a change in their income levels. The higher the income elasticity of demand for a product, the more the demand for a product is linked to the income fluctuations of the customer.
The following income elasticity of demand formula is used for calculation:
Here’s a list of the types of income elasticity of demand:
In such cases, the rise in demand is more than the rise in income. For instance, you shift to a higher-paying job, and your income levels rise. This higher income level might propel you to buy luxury items like cars or plan an international trip.
The change in your income equals the change in demand for such goods. Necessities like electricity, water, petrol, etc., fall into this category.
The quantity demanded is the same, even if your income changes. For instance, your demand for essentials like salt and sugar will not change with a change in income since your consumption will remain the same even if your income doubles.
Goods with a negative income elasticity experience a fall in demand with a rise in the consumer’s income. Inferior goods fall into this category. For instance, say, due to job cuts, you had to shift to consuming inferior goods like margarine instead of butter. However, now that you have a stable income, you might wish to return to buying butter. As a result, the demand for margarine will fall.
Understanding the income elasticity of demand is crucial for both businesses and customers. Here’s why it's important:
The income elasticity of demand is one of the cardinal pillars guiding your spending behaviours. Understanding this concept can help you tweak consumption patterns, optimise spending, and save more. You can also rely on Fi’s AI-powered Analyser to better assess your spending.
Fi's AI-powered Analyser can provide insights to help track your expenses: Analyse your spends by Merchants/Brands, Categories (like Food, Entertainment) & by Time (daily/monthly spends). FYI: Fi also provides thoughtful, non-intrusive nudges to help you maximise your savings/investments. Try it yourself!
Income elasticity of demand measures how demand for goods changes with a change in income. It shows how an increase in income changes the customer's buying patterns.
Income elasticity of demand = (Q1-Q0/Q0)/(I1-I0/I0)
Here, Q0 is the original quantity demanded, Q1 is the new quantity demanded, I0 is the original income, and I1 is the new income.
Income affects customer buying patterns and product demand. Businesses use this information to set prices and marketing strategies. Policymakers adjust monetary and fiscal policies to control industry-based inflationary spending.
For essentials like bread and milk, the income elasticity of demand is positive (between 0-1) since the change in income doesn’t change the demand for essentials to a great extent. However, it's more than 1 for luxury items like cars, suggesting a higher demand with growing income. For inferior goods like millet, it's negative (less than 0) since customers would want to shift to superior alternatives with a rise in income.
Price elasticity of demand tracks demand changes with price, while income elasticity measures changes due to income levels. Both are important in understanding market dynamics because one shows how price affects demand, while the other focuses on real-income changes and their impact on demand.