[1.1.4c] Income elasticity of demand
Income Elasticity of Demand (YED)
Income elasticity of demand (YED) measures how responsive the quantity demanded of a good is to a change in consumer income. It helps classify goods and informs businesses and governments about how demand will change as the economy grows or contracts.
YED = % change in quantity demanded ÷ % change in income
Unlike PED, YED can be positive or negative, depending on whether the good is normal or inferior.
Calculating YED: Worked Example
Worked Example
Scenario: Average household income rises by 8%. Demand for restaurant meals rises from 2,000 to 2,480 per week.
YED = % change in Qd ÷ % change in income
- % change in Qd = ((2,480 − 2,000) ÷ 2,000) × 100 = +24%
- % change in income = +8%
- YED = 24 ÷ 8 = +3.0
Interpretation: YED = +3.0 — restaurant meals are a luxury good. Demand rises more than proportionally when income rises.
Interpreting YED Values
| YED Value | Type of Good | Meaning | Examples |
|---|---|---|---|
YED > 1 | Luxury good | Demand rises more than proportionally as income rises | Foreign holidays, designer clothing, premium cars |
0 < YED < 1 | Normal (necessity) good | Demand rises with income but less than proportionally | Basic food, public transport, utility bills |
YED < 0 | Inferior good | Demand falls as income rises — consumers switch to better alternatives | Own-brand staples, bus travel (when car ownership rises) |
Significance of YED to Businesses and Government
For Businesses
- Firms selling luxury goods (high positive YED) can expect rapidly growing demand in economic booms but must plan for sharp falls during recessions.
- Firms selling necessities (low positive YED) enjoy stable, predictable demand regardless of the economic cycle — a significant competitive advantage.
- Producers of inferior goods may see demand rise during recessions — a counter-cyclical business model. However, long-run growth prospects are limited as rising living standards erode the customer base.
For Government
- YED informs tax revenue forecasting: income and VAT receipts depend on spending patterns that shift with income. In a recession, demand for luxury goods falls sharply, reducing tax receipts.
- YED informs subsidy policy: subsidising inferior goods and necessities (e.g. cheap food staples, public transport) supports low-income households whose consumption of such goods is proportionally highest.
- Knowledge of YED also helps governments assess the distributional impact of indirect taxes — taxing goods with low or negative YED tends to burden poorer households more heavily.
Key Takeaways
- YED = % change in Qd ÷ % change in income. Can be positive or negative.
- Luxury goods (YED > 1): demand rises more than proportionally with income.
- Normal goods (0 < YED < 1): demand rises with income but less than proportionally.
- Inferior goods (YED < 0): demand falls as income rises.
- YED is vital for businesses forecasting demand across the economic cycle and for governments planning tax, subsidy and redistribution policy.