Question

Define the income elasticity of demand. How does the income elasticity of a normal good differ from the income elasticity of an inferior good? Is it possible to tell from the income elasticity of demand whether a product is a luxury good or a necessity good?

Short answer

Income elasticity of demand is a measure of how the quantity demanded of a good responds to a change in income. For normal goods, the income elasticity of demand is positive, while for inferior goods, it is negative. Can also identify if a product is luxury (income elasticity >1) or necessity (income elasticity <1) based on its income elasticity of demand.

Step-by-step solution

Define Income Elasticity of Demand

Income elasticity of demand measures how the quantity demanded for a good responds to a change in consumers' income. It is calculated as the percentage change in quantity demanded divided by the percentage change in income.

Discuss Income Elasticity of Demand for Normal and Inferior Goods

\For normal goods, the income elasticity of demand is positive, meaning that as income increases, the quantity demanded for the good also increases. This is because people can afford to buy more of normal goods as their income increases. \r\nFor inferior goods, the income elasticity of demand is negative. This means that as income increases, the quantity demanded for the good decreases. As people's income increases, they tend to buy less of these goods because they can afford to buy better alternatives.

Discuss Income Elasticity of Demand for Luxury and Necessity Goods

\For luxury goods, the income elasticity of demand is highly positive (> 1), because their demand increases more than proportionately with a rise in income. So yes, it is possible to tell if a product is a luxury good based on its income elasticity of demand. \r\nOn the other hand, necessity goods have a low positive income elasticity of demand (< 1), because their demand increases less than proportionately with a rise in income. Therefore, it is also possible to tell if a product is a necessity based on its income elasticity of demand.

Key concepts

Income Elasticity of Demand

Income elasticity of demand is a key economic concept that assesses how the quantity of a good demanded by consumers changes as their income levels change. It is essentially a measure of how sensitive the demand for a good is to income fluctuations and is expressed mathematically as the ratio of the percentage change in quantity demanded to the percentage change in income. When analyzing the demand for a product, knowing its income elasticity helps businesses and policymakers understand consumer behavior and adjust accordingly.

Normal Goods

Normal goods are products whose demand increases as people's incomes rise. This type of good has a positive income elasticity of demand. In simpler terms, when individuals have more money to spend, they generally choose to buy more of these goods. Examples could include high-quality food items, brand-name apparel, and electronics. The key takeaway is that normal goods signify an improving standard of living and are typically associated with higher quality or enhanced features.

Inferior Goods

In contrast, inferior goods are those where demand decreases as income increases, meaning they have a negative income elasticity of demand. This counterintuitive concept is easily understood by considering what happens when individuals’ incomes grow: they often stop buying cheaper alternatives and switch to more desirable substitutes.

• Generic brands when groceries shopping
• Public transport as opposed to owning a car
• Second-hand clothes instead of new apparel

These are considered inferior goods because they are typically purchased out of necessity rather than desire, and consumers tend to leave them behind as their financial situation improves.

Luxury Goods

Luxury goods are the high-fliers of the economic world. These items have a highly positive income elasticity of demand, usually greater than 1. What does that mean? As people's incomes go up, they don't just buy more luxury goods — they buy a lot more. These are products not necessary for basic living but are deemed as status symbols or are associated with a lavish lifestyle. Luxury vehicles, designer clothing, and expensive jewelry are typical examples. Understanding the elasticity of demand for luxury goods helps businesses target the appropriate demographic and adjust marketing strategies during economic shifts.

Necessity Goods

Necessity goods can be seen as the steady-eddies of the market. These are products with low positive income elasticity of demand, which tends to be less than 1. In simpler terms, even when people's incomes increase, they only buy a slightly higher quantity of these goods, as these products are essential for day-to-day living. Unlike luxury goods, necessities don't often see a massive surge in demand as consumers become wealthier. Staples such as rice, bread, and basic hygiene products fall into this category. Consequently, businesses dealing with necessities should not expect drastic demand changes with economic ups and downs.

Quantity Demanded

The term 'quantity demanded' refers to the exact amount of a good or service that consumers are willing to purchase at a given price over a certain period of time. It's essential to understand that 'quantity demanded' is not simply desire; it's desire accompanied by the capacity to buy. Factors like price changes, consumer income, and preferences typically influence it. With every price shift, the quantity demanded will change, which is plotted as movement along the demand curve, unlike shifts in the demand curve itself, which are caused by those other factors outside of price.