What’s the 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 certain 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 to companies that produce goods and services that are not considered necessities, and is often taken into consideration when setting prices for those products.

One of the assumptions that serves as the basis for the income elasticity of demand is that a shift in the income level will cause a typical household to change its purchasing habits. The general expectation when this income level is lowered for some reason is that the household will continue to purchase basic necessities, even though these items now eat up a larger percentage of disposable 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.

Businesses of all sizes use 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 occurs. 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, book sales will decline. Similarly, a domestic producer of frozen pizzas may find that as income levels decline, consumers increase their purchase of the product, substituting the less expensive frozen pizza for the more expensive night at a pizza joint.

Measuring the income elasticity of demand can also help companies that produce luxury or nonessential products prepare for economic downturns by lowering prices or implementing other strategies that motivate consumers to maintain demand for those products. Often these are advertisements that demonstrate how buying such products is cheaper than similar options and how consumers will actually save money by continuing to buy those products. While this type of approach sometimes reduces the amount of profit made from each unit sold, companies that closely monitor the income elasticity of demand often find that monitoring consumer changes in demand and taking action to make the most of those shifts it can be the difference between staying on and shutting down forever.

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