If consumer income increases, then demand for luxury goods will rise e.g. holidays. If their income falls, then they will cut back on such goods. Goods that you buy more of when your income increases are known as normal goods. They can be split into two categories: necessities and luxury goods.
As consumers’ income rises, they may buy a little more bread, milk etc, and vice versa. Demand changes a little as these products are income inelastic (0 < YED < 1) so changes in income has a very little influence on demand.
As consumers’ income rises, they are much more likely to buy more expensive items such as jewellery. Demand will rise by more than the change in income as it is very income elastic (YED > 1). When a customer’s income increases, they will buy a great deal more luxury goods than prior to this.
Goods that work opposite to the above are inferior goods as more of these are bought when incomes fall. They have superior alternatives but when incomes are low they are cheaper and are used as substitutes. Demand for them falls as income rises (YED < 0) giving them a negative income elasticity of demand. Examples of this would be public transport rather than taxis/cars or supermarket ‘own’ brands rather than branded products.
A value of YED = 1 suggests that demand changes proportionally to income, so the product has unitary income elasticity
SIGNIFICANCE OF INCOME ELASTICITY
- Businesses need to react to changes in incomes and plan accordingly. The usual cause of this is a declining economy e.g. recession.
- When incomes change en masse it will affect a business.
- This causes problems for sellers of luxury goods – they must cope with the falling sales whilst producers of inferior good will see rising sales and must adapt production in line with this.
- Helps firms predict the effect of a business cycle on sales.
- Helps a firm to see how consumers view a product e.g. status.