Income elasticity of demand is an economics concept that is used to measure the responsiveness in the price of a good or service to the change in the income of individuals demanding that good or service. Income elasticity of demand is typically used by producers and investors to forecast anticipated sales, given various market conditions.
Four data points are needed to properly compute the income elasticity of demand for any given good or service. First, it is necessary to determine the "quantity demanded" of the particular good and service at a given point in the past. Second, the average income of purchasers is needed at the same given point in the past. Finally, both the quantity demanded and the average income of purchasers at a second point in time must be calculated.
Income elasticity of demand is calculated by dividing the change in quantity demanded by the change in income. The change in quantity demanded is derived by subtracting the quantity demanded at the second point in time from the quantity demanded at the first point in time. The change in income is derived by subtracting the average income of purchasers at the second point in time from their average income at the first point in time.
Although the equation and calculation itself are relatively simple, there are numerous considerations and outside factors that may affect the calculation. Among the most notable of these is the difficulty in calculating quantity demanded. Quantity demanded represents the amount of a good or service consumers would purchase at a given price level. When businesses constantly raise and lower prices, it is often difficult to compare the quantity demanded at a consistent price level.
Beyond the difficulties in computing quantity demanded, other problems occur when calculating income elasticity of demand. Many analysts will look at the change in real income, which adjusts income for inflation, rather than nominal income, which does not. Other analysts will look at disposable income rather than total income. In addition, when considering the average income of purchasers, it is necessary to adjust for purchasers entering or exiting an economy. Also, when goods or services are improved over time, the value of the improvement should be accounted for.
When the income elasticity of demand for a good or service is calculated to be between zero and 1, the good or service is termed a "normal" good or service. This means demand rises with income, but not disproportionately so. When the income elasticity of demand is greater than 1, the good or service is considered a luxury good or service. Finally, when the income elasticity of demand is less than 1, meaning that demand falls when incomes fall, the good or service is termed "inferior."