1.2.5 Income Elasticity of Demand

Income Elasticity of Demand

Key Definitions

Income Elasticity: The measure of how much the demand for a product changes when there is a change in consumer's real incomes.

Gross Income: The income earned by a consumer before the deduction of any taxes or pension contributions.

Real Income: The income earned by a consumer once inflation rates have been subtracted. Calculated by subtracting the percentage increase in prices from the percentage increase in average earnings.

Necessity Goods: Products that are always needed, so they are considered "essentials" to everyday life, such as bread and milk. These have low, normally positive, income elasticity of demand.

Luxury Goods: Products that are considered "extras" in everyday life, such as a weekend in a fancy hotel, or a new sports car.

Positive Income Elasticity: A product that sees an increase in sales when the consumer incomes see an increase, but see a decrease in times of recession.

Negative Income Elasticity: A product that sees a decrease in sales when the consumer incomes see an increase, but see an increase in times of recession.

Recession: When an economy sees two or more quarters of negative economic growth. 

Real Incomes

The government's Office for National Statistics provides the information on the rate of change for the average earnings per month. The data provided is the gross income, however the real income is more valuable when calculating the income elasticity of demand. The real income is calculated using the equation below:

% change in real income = % increase in average earnings - % increase in prices

A more memorable way to think of the real income is to think of it as the average consumer income after the inflation has been deducted.

Calculating Income Elasticity of Demand 

Income elasticity is the measure of how demand for certain goods and services change when the average consumer income changes.It is massively important as it acknowledges the vulnerability of a company when it comes to changes in the economy. It can be calculated as follows:

Income Elasticity = % change in quantity demanded
                                % change in real incomes

Interpreting the Numbers for Income Elasticity

Products can be put into 3 main categories:

1. Normal Goods

Products with a positive income elasticity of demand, and an income elasticity of demand calculated to be between 0.1 and 1.5.  

2. Luxury Goods

Products with a highly positive income elasticity of demand, and an income elasticity of demand calculated to be greater than 1.5 

3. Inferior Goods

Products with a negative income elasticity of demand.

Factors Influencing the Income Elasticity of Demand

There are many factors affecting the income elasticity of demand of goods and services. The main factors that affect it are as follows:

1. Whether the Product is a Necessity or a Self Indulgence

When people have more money to spend, they are happier to splash out and indulge themselves on luxury goods and services, such as high-end hotels, business-class travel and champagne. These goods all experience sales booms when the economic climate is strong and favourable, however their sales experience a sharp decline in sales when the economy is not performing so well and incomes have fallen. 

For luxury products, income elasticities are strongly positive, and the high income elasticity may be great for when an economy is healthy, but not so great when the economy isn't doing so well. Contrasting this, necessity goods will have a low but positive income elasticity of demand. When real income sees an increase the sales of necessities will typically rise as people are able to buy more of these goods, but the increase isn't typically much. 

2. Who is Buying the Product

Some luxury products are only bought by people who are super rich, with incomes that are not typically affected by changes in real income. It is important to measure the income elasticity of demand for individual brands, especially on the designer markets, as the demands for these brands may not be the same and may, therefore, not have the same income elasticity of demand against other brands on the same market. 

3. Positive and Negative Income Elasticity

When measuring the income elasticity it is crucial that the result is positive or negative. This because, even though an economy may be in a period of recession or economic downturn, companies such as Poundland and Aldi can experience a sales and profit boom. This is because, as real incomes are decreasing, consumers look to shop where they can save a lot of money and buy the same goods at cheaper prices - meaning that these discount shops have a negative income elasticity.

Contrasting this, the majority of products and services have a positive income elasticity of demand, so a lot of spending during times of recession is often decreased. Basically, when we have more income we spend more of it in the shops. Most goods are considered to be 'normal' goods, with an income elasticity of around +1. This means that these goods are not really affected by changes in real income. 

The Significance of Income Elasticity to Businesses

Knowing the income elasticity of demand is massively helpful to businesses in the way that they can help businesses create a well-managed portfolio of products and services. It is helpful for companies to see which of their goods sell well in what economic climate - for example, inferior goods tend to sell well during recessions, and normal goods sell well in periods of recovery etc. The income elasticity of demand helps a business to evaluate their portfolio, and develop a strategy for business growth in the long term. 

The information on the income elasticity of demand for a product is used by businesses for 2 main purposes:

1. Sales Forecasting

A business is able to analyze charts and forecasts showing current and future rates of economic growth and changes in the rates of real incomes. If the forecast was showing figures that are strongly positive, then a business such as Poundland would see their sales flattening off and they can use this to prepare plans for the future and potential decrease in sales. Companies that deal in luxury goods, such as Jaguar Land Rover, would see a massively different forecast, due to the fact that an increase in real income would actually lead to an increase in sales. 

2. Financial Planning

Once a business is able to forecast the future number of sales, it will be able to start planning out the financial side and start budgeting alterations if necessary. If the sales are predicted to boom then the business needs to prepare for higher production rates and, sometimes, a higher volume of additional funding. If the sales are predicted to fall, then the business would need to prepare a plan and budget/budgets in order to reduce their cash flow to survive the period of decreased sales.