Income Elasticity of Demand

Income Elasticity of Demand Think about consumers and their purchases when they first move out on their own. Meals may consist of ramen noodles and a lot of lower-priced foods. However, as time goes by, these same consumers may start earning more money, and inexpensive foods such as ramen noodles are no longer required on the menu. The lower-priced foods may be replaced by steak, fish, chicken, and other higher-priced foods. Firms may make decisions regarding where to locate their businesses or what to sell based on the income demographics of an area. This is where income elasticity of demand is used. Income elasticity of demand tells us how responsive quantity demanded is to changes in income (McEachern, 2019). Income elasticity of demand is calculated using the following formula:

Income Elasticity of Demand

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=

Percentage Change in Quantity Demand

Percentage Change in Income

Calculating Income Elasticity of Demand

We take the same steps when we calculate income elasticity of demand as we did with price elasticity of demand. The difference is that we replace quantity demanded with income. For example, let’s assume the average income in the area around a store that sells cars is $75,000 per year. The total number of cars sold at this income level is 5,000 cars per year. Sometime in the future, the average income increases to $80,000. At this new income level, it is calculated that 6,000 cars will be purchased. Step 1 The first thing to do is to label the prices and quantities. Below are the two prices and quantities, along with their labels:

Income or Quantity Amount Label

Income in the future $80,000 I Income this year $75,000 I´

Quantity in the future 6,000 Q Quantity this year 5,000 Q´

It does not matter if you label the earlier or later price/quantity with the prime symbol (´). You will want to make sure, though, that your labels are consistent, as explained earlier. Step 2 The next step is to calculate the following, using incomes:

(I + I´) =

($80,000 + $75,000) =

$155,000 = $77,500

Step 3 Now, calculate the following using the quantities:

(Q + Q´) =

(6,000 + 5,000) =

11,000 = 5,500

2 2 2 Step 4 The next step is to calculate the change in price.

I – I´ = $80,000 – $75,000 = $5,000 Step 5 Next, calculate the change in quantity.

Q – Q´ = 6,000 – 5,000 = 1,000 Step 6 Divide the result in Step 2 by the result in Step 3.

Step 2 Result

= 77,500

= 14.09 Step 3 Result

5,500

Step 7 Divide the result in Step 5 by the result in Step 4.

Step 5 Result

= 1,000

= 0.2 Step 4 Result

5,000

Step 8 Multiply the result in Step 6 by the result in Step 7.

Result in Step 6

X Result in Step 7

= 14.09 * 0.2 = 2.82

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