Economics Terms A-Z
Income Elasticity of Demand
Income elasticity of demand YEDA is a measure of how the quantity demanded of an item A
In the market for any good or service, how much of it is demanded depends to a large extent on its affordability to buyers. An item’s affordability is determined both by the price at which it is offered and by the buyers’ available budgets. While price elasticity of demand gauges the sensitivity of buyers to changes in the item’s price, income elasticity of demand considers the relationship between budgets and quantity demanded.
The concept of income elasticity is used to classify goods and services into two main types: normal and inferior. A normal good or service is one whose demand moves in the same direction as income. That is, if the buyer’s income increases (falls) then the buyer will demand more (less) of the product. In this case, YEDA
Examples of normal items include consumer goods and services such as clothes, electronic goods, general transport services and theatre and concert tickets. Consumers generally want more as they become better off. Normal goods and services can be subdivided further into the categories of basic necessities and luxury items. Basic necessities are items whose income elasticity of demand is inelastic,
Inferior goods and services include food staples such as bread and shared transport such as public bus services. When income rises and demand for an inferior good or service falls, its consumption is typically replaced by an alternative item with a higher income elasticity of demand. For example, consumers may switch their income away from bread in order to consume more meat, or they may purchase a private car or other more comfortable form of transport to substitute for their public-bus journeys.
Income elasticity of demand is often described graphically using an Engel curve (named after the German statistician Ernst Engel). This is a plot of quantity demanded against income (not to be confused with a demand curve, which shows the relationship between prices and quantity demanded!). In the graph below, the 45° dashed line through the origin represents proportionate responses of buyers to changes in income, i.e. unit income elasticity of demand, YEDA
Aitchison and Brown provide further forms of Engel curves in their article, “A Synthesis of Engel Curve Theory” (The Review of Economic Studies, 1954) and point out that what constitutes a necessity for one income group in the economy may in fact represent a luxury for another income group. Hence their thesis is that Engel curves should be curves rather than straight lines!
Good to know
Economists are often criticised for assuming that more is always better. This may be an unfair claim. Economists tend to focus on the maximisation of individual utility (read: happiness!), which need not always rise with income and consumption. At some point, consumption is saturated. This is manifested through the large gifts and donations that the rich often make to others in the form of charity. Income elasticity of demand is also very relevant in Development Economics; income elasticity tends to be higher at lower levels of economic development.
In capital markets, capital is exchanged between investors (who supply it from their assets) and investees (who need it to fund projects and ventures). The investment horizon is usually at least one year.
A demand curve shows the relationship between an item’s price and the quantity of the item demanded, either by an individual or by all participants in the market. Demand curves are downward-sloping for most items as greater quantities are demanded at lower prices.
Consumer Surplus and Producer Surplus
Consumer surplus is the gain made by consumers when they purchase an item at the competitive market price rather than the (highest) price that they would have been willing to pay for it. Analogously, producer surplus is the gain made by producers when they sell an item at the market price rather than the (lowest) price that they would also have accepted for it.