What’s income elasticity of demand?

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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 consumers’ buying habits. This type of valuation is very important for companies that produce goods and services that are not considered necessary and is often considered when setting prices for these products.

One of the assumptions underlying the elasticity of demand for income is that a change in income level will cause a typical household to change its purchasing habits. The general expectation, when this level of income is reduced for some reason, is that the household will continue to purchase needed items, even though these items now consume a larger percentage of disposable income. At the same time, a family that experiences a significant increase in income is likely to increase more products considered luxurious, maintaining the same level of demand for necessities.

Companies of all sizes use the concept of elasticity of demand to determine how consumers are likely to respond in terms of demand for their products when some type of income shift occurs. For example, a local bookstore will likely determine that if the local economy takes a downturn and households have less disposable income for items they want but don’t necessarily need, book sales will decline. Similarly, a national manufacturer of frozen pizzas may find that when income levels drop, consumers increase purchases of the product, substituting the less expensive frozen pizza for the more expensive night at the pizzeria.

Measuring income elasticity of demand can also help companies that produce luxury or non-essential products prepare for economic downturns by lowering prices or implementing other strategies that motivate consumers to maintain demand for those products. Often this involves advertising that demonstrates how more cost-effective these products are to purchase than similar options and how consumers actually save money by continuing to purchase these products. While this type of approach sometimes reduces the amount of profit earned from each unit sold, companies that monitor income elasticity of demand often find that monitoring changes in consumer demand and taking steps to make the most of those changes can mean the difference between the others in operation and shutting down forever.

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