Economists can gain a lot of information about different types of goods based on how consumer's demand for different goods increases or decreases in response to a change in the consumer's income. For example, new car retailers may be interested in how the quantity demanded for new cars in a specific area is changing. In a case like this, we can look at consumer's income. If the area is growing, and incomes are increasing, we can assume that more new cars will be demanded. On the other hand, if incomes are decreasing, we can anticipate that more people will buy secondhand automobiles or take public transportation.
Of course, we have to remember that an increase in income does not increase the quantity demanded for all goods; BMWs are very different types of goods than Ramen Noodles. Therefore, by looking at the income elasticity, we can measure the responsiveness of the quantity demanded for a good due to a change in income. We can then classify the good as normal, inferior, luxury, or necessity.
Income Elasticity measures the responsiveness of demand due to an increase or decrease in consumer income.
E
= 
change in quantity demanded
change in income
E = Income Elasticity of Demand
Example:
Suppose Frankie Lee's income rises 10% and his consumption of Titleist golf balls increases 5%. Calculate the Income Elasticity as follows...
Income Elasticity of Demand = 5/10 = .5
Characterizing Income Elasticity
Normal Goods (E>0). These are goods whose consumption increases with an increase in income.
- A good example of a normal good is the type of clothes you buy. While you are in college and your income is low, you may shop at Wal-Mart for your clothing. However, after you complete your degree, and you are making a lot of money as an economist, you are more likely to buy more expensive clothes from retailers in a shopping mall. In other words, your consumption increases as your income increases as you buy more expensive clothing.
Necessity (E<1). These are goods whose consumption increases an amount smaller than an increase in income.
-An example of a necessity is drinking water. While you may upgrade to Dasani from Sam's Choice with an increase in income, however, it is unlikely that your consumption of water will increase an amount more than your increase income. For instance, if your income were to increase by 25 percent, you will probably not consume 25 percent more drinking water.
Luxury Good (E>1). These are goods whose consumption increases an amount larger than an increase in income.
-An example of a luxury good is a round of golf. With low income, your consumption of rounds of golf will likely be zero. However, once your income rises enough to afford to play, your increase in rounds of golf will probably be higher than the increase in income. In other words, once you make enough money to play the first round of golf, your increase in round of golf consumption will be 100 percent while the increase in income may have only been 15 percent.
Inferior Good (E<0). These are goods whose consumption decreases with an increase in income.
- A classic example of an inferior good is Ramen Noodles. The idea here is that you will consume fewer Ramen Noodles as your income increases. For example, after you graduate from college, you may have higher quality (more expensive) Chinese takeout instead of Ramen Noodles for some of those quick, late night, meals.
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