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What is Income Elasticity of Demand?

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  • Written By: Malcolm Tatum
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  • Last Modified Date: 19 August 2016
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Income elasticity of demand is a term used to describe the amount of influence a change in income will have on consumer demand for specified goods or services. The idea is to measure the impact that an increase or decrease in income will have on the buying habits of consumers. This type of assessment is very important to companies that produce goods and services that are not considered necessities, and often is considered when setting prices for those products.

One of the assumptions that serves as the foundation for income elasticity of demand is that a shift in income level will cause a typical household to alter its purchasing habits. The general expectation when that income level is lowered for some reason is that the household will continue to purchase necessities, even though those items now consume a larger percentage of the available income. At the same time, a household that experiences a significant increase in income is likely to increase more products that are considered luxuries, while maintaining the same level of demand for necessities.

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Businesses of all sizes utilize the concept of income elasticity of demand to determine how consumers are likely to respond in terms of demand for their products when some type of income shift takes place. For example, a local bookstore will likely determine that if the local economy experiences a downturn and households have less disposable income for items they want but don’t necessarily need, the sales of books will decline. In like manner, a nationwide manufacturer of frozen pizzas may find that when income levels drop, consumers increase their purchase of the product, substituting the less expensive frozen pizza for the costlier night out at a pizzeria.

Measuring income elasticity of demand can also help businesses that produce luxury or nonessential products to prepare for economic downturns by lowering prices or implementing other strategies that motivate consumers to maintain the demand for those products. Often, this involves advertising that demonstrates how the purchase of those products is more cost-effective than similar options, and how consumers will actually save money by continuing to buy those products. While this type of approach does sometimes reduce the amount of profit earned from each unit sold, businesses who monitor income elasticity of demand closely often find that monitoring consumer shifts in demand and taking action to make the most of those shifts can mean the difference between remaining in operation and shutting down forever.

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blaster
Post 11

The given price of elasticity of demand for beef is -1.24 and the income elasticity of demand for beef is .26. I am asked to explain if beef has a high price elasticity of demand, but a relatively low income elasticity of demand.

kentuckycat
Post 8

@JimmyT - What you said about the hotdogs kind of goes along with the last paragraph of the article. If companies are closely monitoring the demand of their products as well as similar products, they can capture the most benefit. I think grocery stores do this all the time without us noticing.

Still keeping with the hotdogs, maybe they will put hotdog buns on sale one week. In a lot of people's minds, maybe the price of those buns will drop to a point where they are willing to pay for them. The buns are useless, though, without hotdogs, so they also have to buy those with it. In the end, everyone theoretically benefits because the customer got a deal

on buns and the store made money on the combination of hotdogs and buns that probably wouldn't have been purchased otherwise.

That follows price elasticity of demand, because the store realized that lowering the price would make the purchase likely for a certain number of shoppers.

JimmyT
Post 7

@TreeMan - I think the terms you might be looking for are substitute goods and complementary goods. Like the name implies, a substitute good is something that people turn to when their willingness to buy one product decreased to a certain threshold.

Using your example, say someone typically buys 4 pounds of steak per month at 5 dollars per pound. If the price goes up to 6 dollars, maybe they'll substitute 1 pound of steak for a pound of hamburger. If the price of hamburger goes up, maybe they'll substitute some steak for hamburger and some hamburger for chicken, etc.

Complementary goods are things that when the price or demand of one item increases or decreases, so does the

price of a complementary item. The classic example of this is hotdog buns. Most people buy buns for their hotdogs so when the demand for dogs goes up, so does the demand for buns, and that is reflected in the price. These two terms are both very important parts of demand elasticity.
TreeMan
Post 6

@Mammmod - The other way to look at your luxury boat example is to think about the company making less expensive goods related to their product. When I was taking economics in college, the example we always used was the beef industry and meat producers.

When times are good, more beef is going to be produced, and a lot of it is going to be sold as high dollar products like steaks and roasts. When the economy goes down a little bit, there will be fewer steaks and more hamburger produced. If the economy goes down even more, people will buy less beef altogether and start buying things like chicken and fish. With your boat example, maybe they start making

smaller boats or start selling accessories for boats.

I really wish I could remember the terms associated with elastic demand. There is one term that describes like the relationship between types of beef and another that describes the switch from beef to chicken.

jcraig
Post 5

@Mammmod - That is a good point you make about buying stocks while they are down like they were in 2008. Fortunately, my job is pretty secure from budget cuts and a general recession, so my income was not affected at all. That put me in a very good position to be able to buy a lot of stocks while they were struggling. There were some stocks that were less than 1 dollar that are today worth 20 or so. Of course, there is always risk associated with buying stocks that low, and some of them I invested in did go under, but the vast majority did not.

That is really the whole goal of investing in the stocks, though

, is to have to ability to invest in those situations. I guess when you really stop to think about it, income elasticity could apply to stocks as well as regular goods that you buy. When you are comfortable financially and have extra money, you can invest it and grow it.
Mammmood
Post 4

@Charred - Elasticity economics is useful in a lot of ways, not only for understanding consumer behavior but also in making investment decisions.

For example, if you have a portfolio with companies that sell luxury items, like golf clubs for example, you may decide to reduce your holdings in those companies during an economic downturn.

You can be sure sales will be sluggish which will be reflected in their stock price. Or you may decide to buy them low during the downturn, in hopes that they will rebound during an economic recovery. In either case, understanding elasticity of demand helps you I think in your investment choices.

Charred
Post 3

@David09 - When I studied economics in college we also learned about the price elasticity of demand too. That basically says that if you tweak the price, you can affect demand.

That proposition needs a little more qualification. For example, if you sell something that nobody really wants, then you won’t be able to sell it no matter how much you slash your prices. That’s my take.

I love getting clearance items however when they’re things I actually want. Clearance items don’t necessarily increase my demand for the product. They do increase my willingness to buy more of it however.

The other day for example I found a bunch of khaki pants that were on clearance for five dollars. I bought a whole bunch of them before the price went back up.

David09
Post 2

@nony - I agree. There’s no such thing as inelastic demand when it comes to income, unless you are simply not wise with money and insist on charging everything up to your credit card so you can live beyond your means. Most people don’t do that.

I do wonder however how producers of luxury items prepare for cyclical downturns. If you make luxury sailboats, certainly you realize that there won’t be demand for your product during a recession.

I suppose you could cut prices a little but I don’t think that will keep your business operating out of the red. My guess is that you have to market and sell aggressively during the profitable years and then buffer a lot of that profit against the cyclical downturns.

That strategy would work as long as a downturn is not protracted in my opinion.

nony
Post 1

Elastic demand is a concept that makes sense in my opinion and is one of those few economic concepts that are not really debatable. It’s easy to prove. When the economy goes down, demand for luxury items dwindles.

I am sure that there is an array of statistics to prove that point. As far as anecdotal evidence, I can put in my own two cents worth. During one economic downturn we made drastic cuts in our luxury purchases.

We ate out a lot less, watched more movies on television instead of going to the theater, and I took a lot of brown bag lunches to work. These changes took a lot of discipline; but it’s not as if we had much choice.

Either increase the income, or reduce the expenses. The income was reduced, so we cut our expenses for luxury items.

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