Income Elasticity of Demand

Income elasticity of demand measures the responsiveness of the quantity demanded of a good to a change in income, holding other factors constant. It is defined as the percentage change in quantity demanded divided by the percentage change in income.

Definition and Classification

The income elasticity of demand may be positive or negative. A positive elasticity means that the quantity demanded rises with income, as is the case for most goods.

Goods with a positive income elasticity are classified by the size of the elasticity. Goods with an elasticity between zero and one are necessities, since the quantity demanded rises less than proportionally with income. Goods with an elasticity greater than one are luxuries, since the quantity demanded rises more than proportionally.

Goods with a negative income elasticity are inferior goods, since the quantity demanded falls as income rises. Consumers switch away from these goods as their income increases, in favour of higher-quality substitutes.

Engel's Law

Engel's law states that the share of income spent on food declines as income rises. The law implies that the income elasticity of demand for food is less than one, so that food is a necessity. The law is one of the most robust empirical regularities in economics.

The law has implications for the structure of the economy. As income rises, the share of expenditure on food declines, and the share on other goods and services rises. The composition of output and of employment shifts accordingly.

The law also has implications for development. As countries grow, the demand for agricultural products grows more slowly than income, so that the agricultural sector declines relative to the rest of the economy. The process of structural transformation is driven in part by these differences in income elasticities.

Measurement

The measurement of income elasticity requires data on the quantities demanded and on incomes, and it must control for other determinants of demand, including prices. The estimation is complicated by the endogeneity of income and by the need to distinguish the effect of income from that of other factors.

The estimates vary across goods, across countries, and across income levels. The elasticity of demand for a good may differ between rich and poor households, which matters for the analysis of distributional effects.

The measurement is also affected by the level of aggregation. The elasticity for a broadly defined category may differ from the elasticity for a particular good within the category, since substitution occurs within as well as between categories.

Applications

The income elasticity of demand is used in the analysis of the effects of growth on the composition of demand and of output. It is used in the analysis of the effects of redistribution, since a transfer of income from rich to poor changes the composition of demand according to the income elasticities of the goods consumed.

The elasticity is used in the analysis of tax policy, since the incidence of a tax depends in part on the income elasticity of demand. It is used in the analysis of trade, since the income elasticities of demand for imports and exports affect the trade balance as income grows.

The elasticity is also used in forecasting, since projections of demand require estimates of how demand responds to changes in income.

Necessities and Luxuries

The classification of goods as necessities or luxuries has important implications for the analysis of the economy. Necessities have income elasticities between zero and one, so that their share of expenditure declines as income rises. Luxuries have elasticities greater than one, so that their share rises.

The classification is not fixed, since the income elasticity of a good may change as income rises. A good that is a luxury at low incomes may become a necessity at higher incomes, as it is adopted by the general population.

The classification affects the analysis of the effects of growth. As income rises, the composition of demand shifts towards luxuries and away from necessities, and the structure of production adjusts accordingly. The process of structural transformation is driven in part by these differences in income elasticities.

The Role of Income Distribution

The income elasticity of demand is relevant to the analysis of income distribution. A redistribution of income from rich to poor changes the composition of demand, since the two groups consume different baskets of goods.

The effect of redistribution depends on the difference in the income elasticities of the goods consumed by the two groups. If the goods consumed by the poor are more income-elastic, redistribution raises the demand for them and reduces the demand for the goods consumed by the rich.

The analysis of redistribution must therefore consider the composition of demand as well as its level. The redistribution can affect the structure of production and of employment, and it can have effects on the prices of the goods consumed by different groups.

Estimation and Data

The estimation of income elasticity requires data on household expenditure and on income, and it must control for the determinants of demand. The estimation is complicated by the endogeneity of income and by the need to distinguish the effect of income from that of other factors.

The data are typically drawn from household surveys, which provide information on the expenditure and the income of a sample of households. The surveys differ in their coverage and in their definitions, and the estimates must be adjusted for these differences.

The estimates vary across countries and over time, and they are subject to uncertainty. The use of the estimates in policy analysis requires attention to their precision and to the assumptions on which they rest.

Summary

The income elasticity of demand measures the responsiveness of demand to income and underpins the classification of goods as necessities or luxuries. Its analysis informs the understanding of structural transformation, of the effects of redistribution, and of the taxes and of the trade policies.

See also

• Elasticity
• Consumer Behaviour
• Market Basket