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Ismail Hassan
Income Elasticity of Demand

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We learned earlier that we could measure the elasticity of demand of any good against price. A change in price will cause changes in quantity demanded and using a simple formula (change in quantity/quantity x price/change in price), we will be able to determine what percentage change in quantity demanded will be if price increases by 1%. We say that if the quantity demanded of a good changed by less than 1%, the good is price inelastic. If, however, quantity demanded changed by more than 1%, the good is price elastic. In cases where percentage change in quantity demanded equals to percentage change in price, we say the good has unit-elastic demand. In instances when there are no changes in quantity demanded regardless of the change in price, the good is said to have perfectly inelastic demand, and when there is indefinite change in quantity demanded even with the slightest change in price, we say the good has perfectly elastic demand.

Like price, changes in income also have an impact on elasticity of demand. For some goods, even a small change in income will result in a large change in quantity demanded. And yet for some other goods, a large change in income may only cause a small change in quantity demanded. Income elasticity of demand measures the sensitivity of quantity demanded of goods or services because of changes in income. We will calculate what will be the change in quantity demanded as a result of changes in income.

If a 1% change in income results in an exact 1% change in quantity demanded, then we say the good has income unit-elastic. In situations when a 1% change in income results in a greater than 1% change in quantity demanded, then we say the good is income elastic, and when a 1% change in income results in a less than 1% change in quantity demanded, we say the good is income inelastic.

High income elasticities, such as are found for airline travel, VCDs, or designers jeans, indicate that the demand for these goods rises rapidly as income increases and drops rapidly too as income decreases. Low-income elasticities, such as for food or cigarettes, denote a weak response of demand as income rises or drops.

HOW TO CALCULATE INCOME ELASTICITIES? Remember that we are measuring the percentage change in quantity demanded as a result of a change in income. So what we need to do is to calculate the percentage change in quantity demanded and also to calculate the percentage change in income. Once you get the answers for both, make the appropriate conclusion (see below).

To calculate, use the following formula:

Change in Quantity x _____Income___

       Quantity             Change in Income

For example, the average income of Malaysians increases from RM2000.00 a month to RM2350.00 a month. On the previous average income of RM2000.00, they bought 100 units of VCD players. With the new income, the quantity demanded rises to 120 units. Calculate the income elasticity.

The formula is:

Change in Quantity x _____Income___

       Quantity           Change in Income

Change in Quantity = 20 (120 units 100 units)

Change in Income = RM350.00 (RM2350.00 RM2000.00)

_20 x RM2000.00

100    RM350.00

0.2 x 5.71

1.14

Based on the calculation, a 1% increase in income results in a 1.14% increase in quantity demanded. Therefore, it is concluded that (#1 below): The percentage change in quantity demanded is higher than the percentage change in income and as such the demand for VCD players is income elastic.

Alternately, you may also use this formula that is more precise.

Change in quantity divide by Change in Income

      (Q1 + Q2)/2                    (Y1 + Y2)/2

_______20_____ divide by _______RM350.00______

(100 + 120)/2                (RM2000.00 + RM2350)/2

_20     divide by    RM350.00_

110                     RM2175.00

0.18 divide by 0.16

1.13

Based on the above calculation, a 1% increase in income results in a 1.14% increase in quantity demanded. Because the change in quantity demanded is greater than 1%, we conclude that the demand for VCD players is income elastic.

CHOICES OF CONCLUSIONS AFTER MAKING REQUIRED CALCULATIONS

  1. The percentage change in quantity demanded is higher than the percentage change in income. (Income elastic Change in quantity demanded > 1%)
  2. The percentage change in quantity demanded is lower than the percentage change in income. (Income inelastic (Change in quantity demanded < 1%)
  3. The percentage change in quantity demanded is equal to the percentage change in income. (Income unit-elastic Change in quantity demanded = 1%)
  4. There is no change in quantity demanded although there is a change in price. (Income perfectly inelastic There is no change in quantity demanded)
  5. There is an indefinite change in quantity demanded resulting from a change in price. (Income perfectly inelastic There is indefinite change in quantity demanded)