Income elasticity of demand

Income elasticity of demand (IED) estimates how strongly demand for a good or service changes when customer income changes. It can turn an economic-growth forecast into a first-pass market-demand forecast when the market and elasticity estimate are appropriately matched.

When to use it

Use IED when the target market is sufficiently large and homogeneous for a credible public, academic or internally estimated elasticity to apply. It is less useful for narrowly defined segments with distinct buyers, substitutes or constraints.

Origins

The concept grew from nineteenth-century empirical work on household expenditure. Ernst Engel observed that food’s share of household spending tends to fall as income rises, even when absolute spending grows. Economists later expressed such relationships as elasticity: percentage change in quantity demanded divided by percentage change in income. No single study supplies a permanent elasticity for a market; the estimate depends on period, population and definition.

What it is

IED = percentage change in demand ÷ percentage change in income.

If income rises by 3 per cent and demand rises by 4.5 per cent, IED is 1.5. If demand rises by only 1 per cent, IED is 0.33. The sign and magnitude support a conventional classification:

• A positive IED describes a normal good.
• Below 1, demand is relatively income-inelastic and the good is often described as a necessity.
• Above 1, demand is more responsive and the good is sometimes called superior.
• Above 2, it may behave like a luxury, with pronounced movement across economic conditions.
• Around 0, demand changes little with measured income.
• Below 0, the good is classified as inferior because demand tends to fall as income rises.

These labels describe observed demand behaviour, not product quality or social value. Elasticity can change as income levels, preferences, prices, substitutes and market composition change.