key term - Income Elasticity of Demand

Definition

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

5 Must Know Facts For Your Next Test

1. Income elasticity of demand measures the percentage change in quantity demanded of a good or service in response to a 1% change in consumer income.
2. The value of the income elasticity of demand can be positive, negative, or zero, indicating whether the good is a normal good, inferior good, or neutral good, respectively.
3. Goods with a high income elasticity of demand are considered luxuries, as their demand increases more than proportionately with income.
4. Goods with a low income elasticity of demand are considered necessities, as their demand increases less than proportionately with income.
5. The income elasticity of demand is an important factor in understanding how changes in consumer income affect the demand for different types of goods and services.

Review Questions

• Explain how the income elasticity of demand for a good or service is calculated and interpreted.
  • The income elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in income. A positive value indicates a normal good, where demand increases as income increases. A negative value indicates an inferior good, where demand decreases as income increases. The magnitude of the value reflects the responsiveness of demand to changes in income, with higher values indicating a more sensitive, or elastic, relationship.
• Describe the relationship between the income elasticity of demand and the classification of goods as normal, inferior, or neutral.
  • The income elasticity of demand is used to classify goods as normal, inferior, or neutral. Normal goods have a positive income elasticity, meaning demand increases as income rises. Inferior goods have a negative income elasticity, where demand decreases as income increases. Neutral goods have an income elasticity of zero, indicating demand is unaffected by changes in income. The magnitude of the income elasticity also provides insight, with high values suggesting luxury goods and low values indicating necessities.
• Analyze how changes in consumer income can affect the demand for different types of goods and services based on their income elasticity of demand.
  • $$\text{The impact of changes in consumer income on the demand for a good or service depends on its income elasticity of demand.}\text{For normal goods with a positive income elasticity, an increase in income will lead to an increase in demand, while a decrease in income will reduce demand.}\text{For inferior goods with a negative income elasticity, an increase in income will decrease demand, as consumers substitute towards higher-quality normal goods. A decrease in income will increase demand for inferior goods.}\text{The magnitude of the income elasticity also matters, as goods with high elasticity (luxuries) will see larger changes in demand compared to goods with low elasticity (necessities).}$$

Related terms

Demand: The willingness and ability of consumers to purchase a good or service at various prices during a given time period.

Normal Goods:

Goods for which demand increases as income increases, with a positive income elasticity of demand.

Inferior Goods:

Goods for which demand decreases as income increases, with a negative income elasticity of demand.