In any market niche, demand for any product is directly proportional to the income of the consumers, and income elasticity helps businesses in gauging these dynamics. In this article, we are going to unravel the hidden concepts of Income elasticity, and understand how it can help you in making better business decisions.
So, let us get started right away-
Introduction to the Income Elasticity
Often when we receive a bonus or get paid, the first thing that we do is we opt for shopping for various products.
But no one might have imagined how sudden spree of shopping might have affected the demand for some product. While the need for some items changes with change in income, some items may remain unaffected by a change in income.
Here comes the concept of income elasticity of demand.
One of the crucial determinants of a product’s demand is consumer’s income.
There is a direct relationship between the consumer’s income and demand for a product. The amount of income a consumer spends on buying products affects the need for the product.
What is Income Elasticity?
Income elasticity of demand evaluates the relationship between change in real income of consumers and change in the quantity of product. It denotes how sensitively the number of goods demanded depends upon the change in income of consumers who buy; all other parameters kept constant.
In its formula, it is denoted by the change in percentage of quantity demanded concerning the change in percentage of income, that is, it is the ratio of mention two percentage changes.
Income Elasticity of Demand = % change in quantity demanded / % change in income
This ratio helps to decide if a particular product is a luxury or a necessity.
If the ratio is higher than one, then it implies that the goods are in the luxury category.
One can measure how responsive the demand is to the change in income.
Let us understand this with an example-
Example of Income Elasticity
Suppose there are two products X and Y.
An increase of 10 percent in income and an increase of 25 percent in demand imply proportionality that the latter has with former.
Here, product X has thus elastic demand for income.
Such products are fashion accessories, cars, holidays, entertainment and several luxury products.
Let the demand for product Y rises only by 2 percent. This would imply that product Y has inelastic demand concerning income.
This is due to the reason that here the demand for Y is less proportional to the increase in income. These are goods like food, milk, etc.
In we apply formula here to calculate Income Elasticity of both the products then it would be-
Income Elasticity of Product X= 25% / 10% = 2.5
Income Elasticity of Product Y= 2% / 10% = 0.5
While going through the discussion, you must have noticed some of the terms that are integral parts of the Income Elasticity concept and their naming are based upon the numerical value of income elasticity. Let us discuss them as well-
Key Terms Associated with Income Elasticity of Demand Concept
1) Normal Goods
- These goods have a positive ratio of income elasticity. Graphically, an outward shift can be observed in the demand curve.
- The income elasticity for standard necessities lies between 0 and 1. Therefore, also known as necessity goods. Suppose, consumer income increases by 10 percent and demand for vegetable increases by 4 percent. This implies an income elasticity of +0.4. A few examples of necessity goods are water, haircuts, electricity, etc.
- Income elasticity for luxury goods is greater than 1. This means that the increase in demand is more than a proportional increase in consumer income. Suppose, consumer income increases by +8 percent and demand for production increased by +10 percent. This implies an income elasticity of +1.25.
2) Inferior Goods
- These are the goods with negative income elasticity of demand. This means if consumer income increases, demand falls. A few examples are cigarettes, local label foods, etc.
- If consumer income rises, they buy fewer goods.
3) Luxury Goods
- These are the goods with income elasticity more significant than one.
- Consumers tend to buy more than proportional to the increase in their income.
- A few examples include luxury cars, jewelry,
- These are the products that are most sensitive to change in consumer income.
Different Types of Income Elasticity of Demand
- High Income Elasticity – A rise in income is followed by even more significant increases in the quantity demanded.
- Unitary Income Elasticity – An increase in income is proportional to the rise in the quantity demanded.
- Low-Income Elasticity – A rise in income is less than the increase in the quantity demanded.
- Zero Income Elasticity – The quantity demanded remains the same even if income changes
- Negative Income Elasticity – An increase in income is followed by a fall in volume demanded.
Factors Which Affect Income Elasticity
The most significant factors which affect the said term are luxuries and necessities.
Necessities can be defined as the ordinary products which one needs to carry out their everyday business. The products which a person needs in their regular life are termed as necessities. For example, water, electricity, and food. These kinds of commodities are categorized under income inelastic.
Luxuries are the type of products that a person purchases only if they can have them. The amounts to be spent to have these goods are discretionary. Hence, the demands of these goods are categorized under income elastic.
For example, satellite television, air travel, and many others. It has been concluded from the studies that the demand for foreign goods is also considered as income elastic.
Benefits of using Income Elasticity
The concept of price elasticity plays an essential role in deciding the total revenue of the firm by determining the price of the product in the short run. In the same way, income elasticity is beneficial in product management and planning in the long term.
Here, the article will discuss some essentiality of income elasticity:
1) Helps in making better investment decisions
The income elasticity plays a critical role in deciding the amount and term of the investment. For example, as India is a developing country, it is the rate at which the national income is growing is almost steady as that of the developed country. Here, the rise in the national capital does not immediately affect the price of the commodities.
Now, the term national income becomes very critical for the seller as he/she needs to allocate the number of resources based on the same. Usually, a seller will prefer to invest in a market where the demand for the commodity is more when compared to the proportionate change occurring in income. These commodities can be vehicles, electrical appliances as well as furniture. The price of these commodities rises with the increase of the national income.
2) Helps businesses in Forecasting Demand
Income elasticity also helps in getting educated about the demand for the product shortly. If one witnesses a significant change in the income, then the need for the product will also see a considerable difference. The same occurs when the customers become aware of the change that is reflected in the income; they tend to change their taste in that product as well.
Also, if the change is temporary, then the demand will not get affected significantly. But then, the need for any commodity is not guided by the income itself.
3) Assists in Categorizing goods in a profit-driven manner
The above states that one can classify the goods based on the demands for them in the market. The classes in which the products are categorized are inferior goods, common goods, and essential goods.
This classification propels the seller in deciding the quality and quantity of the goods to be produced and sold in the market. The categorization also helps to target the different financial sections of the customers.
Role of Income Elasticity of Demand to a Business
Here are the ways through which Income Elasticity of demand plays its part in running a successful business-
1) A company selling goods with high-income elasticity
The demand of products are increasing day by day; although they are of fashion, entertainment, air travels, restaurants, hotels or any affordable goods that aren’t necessities, these are associated with the products that are included in luxuries, it means the goods which are high in income but not in demand.
As these are also growing day by day, yet there can be a time when the economy falls, and there is a recession in demand also falls. This process is cyclical and not stable.
2) A business selling goods with low-income elasticity
These are associated with the necessities. Therefore, the demands for these goods are steady. Let’s take an example of a farmer since he’s not affected by the income because the necessities and need of the products somehow make it stable as compared to those goods which are income elastic.
This makes the business planning a bit accessible and straightforward as that of business selling goods with high-income quality. Therefore, these goods which are income inelastic have less chance to get diversified, and they remain stable.
3) Production Planning
By knowing the income elasticity of demand for their products or services, businesses can efficiently plan the production as per the suggested changes in the income of target audiences.
Therefore, if the income of any good is increasing in demand then the business can prepare for the future benefits and their productions, similarly, when there is a chance of a decrease in need of the product, they can sell it at low-cost income.
4) Production Switching
People nowadays often have different resources of the production of their goods, so that when any of their items are low in demand, then they can switch to the other products of the same output.
For example, if they are a manufacturer of plastic, then they can either go for selling toys, household goods, accordingly, as per the demand in the market.
Income Elasticity Wrap Up!
Now, on the concluding note, we hope you would have understood the importance of income elasticity and their role in making productive business decisions.
By measuring income elasticity of demand, businesses can forecast how the demand for their products is going to change shortly with the change in the income of the consumers. According to the reports, the business can improve its manufacturing, marketing, and advertising strategies.
So, for better prediction of the sales cycle for your business, it is essential to pay heed to the concepts of Income Elasticity of Demand.
How important do you consider income elasticity for better business decisions? Share with us in the comments below.