The sensitivity of the quantity desired for a specific good to a change in the real income of consumers who buy this commodity is referred to as income elasticity of demand.

The income elasticity of demand is calculated by dividing the percent change in quantity demanded by the percent change in income. With income elasticity of demand, you can determine if a given commodity is a need or a luxury.

The following formula is used:

Income Elasticity of Demand   = % Change in Demand Quantity / % Change in Income of Consumer

Where:

% Change in Demand Quantity = Change in Demand Quantity / Original Demand Quantity

% Change in Income of Consumer = Change in Income of Consumer / Original Income of Consumer

(OR)

YED = % ∆ in Qd/% in ∆Y

(OR) 

YED= (D₂-D₁) ÷D₁ / (Y₂-Y₁) ÷Y₁

We can express this as the following:

YED = (New Quantity Demand – Old Quantity Demand)/(Old Quantity Demand) / (New Income – Old Income)/(Old Income)

When the YED is low, changes in consumer income have minimal influence on product demand.

Income elasticity of demand is a helpful statistic used by governments and businesses to identify the sort of goods to be made as well as the influence of changes in income on the demand for those firms’ products.

It may be used to predict a country’s economic development as well as the income of its citizens.

The higher the income elasticity of demand for a certain commodity, the more demand for that good is linked to changes in consumer income. Businesses, for example, usually assess the income elasticity of demand for their products in order to foresee the impact of a business cycle on product sales.

Goods can be broadly classified as inferior or normal based on the values of the income elasticity of demand. Normal products have a positive income elasticity of demand, which means that as income levels grow, more products are sought at each price level.

Normal items with an income elasticity of demand between zero and one are commonly referred to as necessary goods, which are products and services that consumers will purchase irrespective of their income fluctuations. Cigarettes, hairdressing, water, and electric power are examples of necessary commodities and services.

As income grows, so does the share of overall consumer spending on necessities. Inferior goods have a negative income elasticity of demand; as income grows, people purchase less inferior products. Margarine, which is substantially cheaper than butter, is an example of such a product.

Furthermore, luxury goods are a form of normal good with demand income elasticities larger than one. In response to a percentage change in their income, consumers will buy proportionally more of a certain product. Premium vehicles, yachts, and jewellery are examples of consumer discretionary products that are very susceptible to variations in consumer income. When the business cycle moves downhill, consumer discretionary goods demand tends to fall as employees lose their jobs.

The sensitivity to changes in consumer income relative to the amount of a good that consumers’ desire is referred to as income elasticity of demand. Highly elastic commodities will have a quick shift in quantity demanded as income changes, whereas inelastic goods will have the same quantity demanded as income varies.