Income Elasticity

When you get a pay raise, you feel like you’re on top of the world...king of a fatter wallet. With all that dough, you’re starting to feel more flexible. Income elasticity, also known as “income elasticity of demand,” is a way to measure how changes in income change consumer demand.

Income elasticity is calculated by taking the percent change in demand and dividing it by the percent change in income.

Back to that pay raise of yours. As income rises, we can expect to see the demand for “normal goods” to rise. Actually, that’s kind of the definition of normal goods. Normal goods aren’t things you “normally” buy...they’re just goods you want more of when you have more money in your pocket.

A normal good for you might be gourmet coffee. For your sister, a normal good might be more quality, fashionable clothes. For your weird uncle, more income might mean “artistic” statues in his backyard. To each his own, right? As long as you start demanding more of a good in response to more money to pay for it, you have a positive income elasticity for that good, which means it’s a normal good.

For instance, let’s say you got a 10% raise, which caused you to buy 5% more coffee. That would mean 5% increase in demand divided by 10% increase in income, or a positive income elasticity of +0.5. We can smell the freshly ground coffee beans now.

Let’s say that, a month later, your boss said “Psych! No raise for you!” Bummer. We’d simply switch the signs: -5% divided by -10% still equals +0.5 income elasticity. On a graph where quantity demanded is on the x-axis and income is on the y-axis, normal goods are sloping upward. The more money we have, the more of that normal good we will want to buy.

The opposite of normal goods are inferior goods, which are goods that have a negative income elasticity. Inferior goods are goods you can live without, i.e. goods you demand less as income rises. It may or may not be true for you, but for many people, fast food is an inferior good. Not because most of it is made out of chicken intestine and pig hooves, but because it has a negative income elasticity.

Remember when your boss took back that pay raise? It meant less gourmet coffee (a normal good) and more fast food coffee (an inferior good). The initial 10% pay raise led to an 8% decrease in your consumption of watery, Micky D’s coffee. So, -8% divided by +10% = -0.8 income elasticity.

When your boss took back the pay raise, grumble grumble, your income went down, and consumption of bitter, burnt, fast-food coffee went back up: +8% divided by -10% = -0.8. Inferior goods are downward sloping: the more money we have, the less of that good we’ll want to buy.

What about goods you buy the same amount of, no matter what your income? Things like water and toilet paper? On the graph, if the “Q” stays the same regardless of a change in income, then the curve for that good would be a straight line upward.

20% raise? 10% pay cut? Doesn’t matter: still the same amount demanded. That makes our percent-change in demand on top zero, since, well, there was no change. If you went from buying one bundle of TP before a raise to one bundle of TP after the raise, that’s a change of zero.

And zero divided by anything is zero, which hopefully makes sense.

But what about luxury goods?

As it turns out, luxury goods are just a type of normal good...except more expensive, usually. A luxury good is a normal good, because it is it has a positive income elasticity. What makes it different? It has to have an income elasticity greater than one.

For example, let’s say a 10% increase in your uncle’s income resulted in a 20% increase in demand for his weird yard art. In our formula, that would mean +20% is on top and +10% is on the bottom, for an income elasticity of 2.

Think about what an income elasticity of at least “one” means. Your increase in demand for a good must be the same as the increase in your income...or greater. What makes luxury goods “luxury” is being able to afford to buy more of something than the proportion of your increase in income.

There are a lot of things you’d rather buy than that those odd things your uncle is decorating his yard with, but, well, different strokes for different folks, as they say. Luxury is in the eye of the consumer.