Income Elasticity of Demand (YED)

What YED Measures

Income elasticity of demand (YED): how much the quantity demanded of a product responds to a change in consumers' real income.

Real income is income adjusted for inflation, so it measures what people can actually buy (unit 1.3.1). It rises when the economy grows and can fall in a recession.

Calculating YED

YED compares two percentage changes: \[ \text{YED} = \frac{\%\text{ change in quantity demanded}}{\%\text{ change in real income}} \]

Interpreting the Value of YED

The sign of YED tells you whether demand moves with income or against it.

• Normal good: a product whose demand rises when income rises, so YED is positive.
• Inferior good: a product whose demand falls when income rises, so YED is negative.

The size of the number gives the strength of the response. A YED of +2.4 means a 1% rise in real income raises quantity demanded by 2.4%. At exactly 1, demand changes by the same percentage as income. At 0, it does not change at all.

Why YED Matters to Firms

Incomes rise and fall with the economic cycle (unit 2.5.1), and YED tells a firm what that will do to its sales.

• Sellers of luxuries in a boom: real incomes rise → demand grows faster than income → sales and profit rise → the firm hires staff and invests in extra capacity.
• Sellers of luxuries in a recession: real incomes fall → customers cut back on luxuries first → sales fall sharply → lower profit, and jobs at risk.
• Sellers of inferior goods in a recession: shoppers trade down → demand rises → discount retailers and budget brands gain sales and market share.
• Sellers of necessities: demand barely moves either way → steady sales through the cycle.

Firms use this to plan:

• A product portfolio: a supermarket with a premium range and a budget range sells more of one when it sells less of the other, so its total sales are steadier across the cycle.
• Output and stock: a car dealer expecting a downturn orders fewer new cars and more used ones.

How much a firm can rely on YED depends on:

• How accurate the estimate is: YED is worked out from past data, and tastes change.
• Whose income is changing: average income can rise while the firm's own customers are worse off.

Factors Influencing YED

Whether YED is high, low or negative depends on:

• How essential the product is: necessities have low YED, because people buy them whatever their income. Luxuries have high YED.
• The customer's income level: the same product can be a luxury for a low-income household and a necessity for a high-income one. As a country gets richer, goods such as cars move from one group to the other.
• Whether better alternatives exist: a product is inferior when people swap it for something they prefer as they earn more, such as bus travel for a car.