Income Elasticity of Demand

Next, let’s discuss the income elasticity of demand. Here, we compare people’s incomes to the quantity demanded of a good. The objective is to determine whether something is a normal good or an inferior good.

When income increases, the demand for normal goods will also increase. People have more money, so they desire more of a normal good. Conversely, the demand for inferior goods will decrease. Here’s the formula for income elasticity of demand:

Income Elasticity of Demand = % Change in Quantity Demanded / % Change In Income

A normal good is something that people want more of when their income increases. Consider the example of dining at a high-end restaurant. As people earn more, they are more willing to spend money at high-end restaurants. Let’s assume people earn 5% more income and, therefore, the quantity demanded for high-end restaurants increases by 5%. The income elasticity of demand is 1 (5% change in quantity demanded / 5% change in income).

A positive number indicates a normal good. A negative number denotes an inferior good. In this case, we have a +1 income elasticity of demand, suggesting that high-end restaurants are a normal good.

Now, let’s look at an example of an inferior good. An inferior good is something people want less of when they earn more (e.g., fast food restaurants). When people earn less, they consume more fast food in an attempt to save money. Conversely, when they earn more, they prefer to spend on more luxurious dining experiences, like high-end restaurants.

Suppose incomes increase by 5%, and as a result, the change in quantity demanded for fast food restaurants decreases by 3%. The income elasticity of demand is therefore -0.6 (-3% change in quantity demanded / 5% increase in income). Since it’s negative, it shows that this is an inferior good.

Study Tip: A Positive Income Elasticity of Demand = Normal Good; A Negative Income Elasticity of Demand = Inferior Good