Uses of Income Elasticity of Demand in Business Decision Making

What is income elasticity?

Income elasticity of demand is the measure of change in demand of the commodity as a result of a change in income of the consumers. It is denoted by Ey, and is mathematically expressed as

Mathematical expression of income elasticity

Uses of Income Elasticity of Demand

1. To classify normal and inferior goods

Any products that are manufactured by the producers can be classified into two types – normal goods and inferior goods.

Normal goods – Goods whose demand is directly proportional to the income of the consumers are known as normal goods.
Simply, goods whose demand rises with a rise in income and whose demand falls with fall in income is known as normal goods e.g jewelry. The coefficient of income elasticity of these goods is always positive.

Inferior goods – Goods whose demand is inversely proportional to the income of the consumers are known as inferior goods.
In other words, inferior goods are such goods whose demand falls with the rise in income and vice versa e.g. budget smartphones. The coefficient of income elasticity of these goods is always negative.

Knowledge about the nature of products is important to any producers in order to make further decisions related to the goods in the right manner.

2. To know about stage of trade cycle

We have already known that demand for normal goods is directly proportional to the income of consumers while demand for inferior goods is inversely proportional to the income of consumers.

We see people prefer riding the public bus when their income is low, but with comparatively high income, same people start using a cab for transportation. In this situation, public bus is an inferior good while the cab is a normal good.

Demand for normal goods increases during prosperity and decreases during regression. Conversely, demand for inferior goods increases during regression and decreases during prosperity. However, demands for goods that are necessary for our day to day lives are not much affected during prosperity as well as during regression.

Figure: Trade cycle

Graphical representation of trade cycle

3. For forecasting demand

Income elasticity of demand can be used for predicting future demand of any goods and services in a case when manufacturers have knowledge of probable future income of the consumers.

For example: Let us suppose, ‘Wheels’ is a car manufacturing company which manufactures luxury cars as well as small cars. The company has calculated that income elasticity of luxury car (normal good) is +4 while income elasticity of small car (inferior good) is -5.

Let us also suppose that the company has undertaken a research and has found that consumer income will rise by 3% in an upcoming year.

Through the above information, Wheels can forecast by how much the demand for luxury car and the small car will undergo a change in the upcoming year. This information can save the company a lot of money by preventing overproduction or underproduction.

4. To determine price

Having knowledge of income elasticity of any product is essential in order to correctly price them.

The demand for income elastic goods or goods with positive income elasticity tends to fall with fall in income of the demanding consumers. Thus, a reduction in the price of the commodity may help in increasing the demand and compensate them for the reduction in price by generating more sales and revenue.