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In general, elasticity is simply a measure of how sensitive one variable is to change in the value of another variable. Quantity demanded of a good is a function not only of its own price, but also consumer income. If income changes, the quantity demanded can respond, so the analyst needs to understand the income sensitivity as well as price sensitivity.
Income elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in income (I), holding all other things constant, and can be represented as in Equation 25.
Note that the structure of this expression is identical to the structure of own-price elasticity in Equation 24. Indeed, all elasticity measures that we shall examine will have the same general structure, so essentially if you’ve seen one, you’ve seen them all. The only thing that changes is the independent variable of interest. For example, if the income elasticity of demand for some good has a value of 0.8, we would interpret that to mean that whenever income rises by one percent, the quantity demanded at each price would rise by 0.8 percent.
Although own-price elasticity of demand will almost always be negative because of the law of demand, income elasticity can be negative, positive, or zero. Positive income elasticity simply means that as income rises, quantity demanded also rises, as is characteristic of most consumption goods. We define a good with positive income elasticity as a normal good. It is perhaps unfortunate that economists often take perfectly good English words and give them different definitions. When an economist speaks of a normal good, he is saying nothing other than that the demand for that particular good rises when income increases and falls when income decreases. Hence, if we find that when income rises, people buy more meals at restaurants, then dining out is defined to be a normal good.
For some goods, there is an inverse relationship between quantity demanded and consumer income. That is, when people experience a rise in income, they buy absolutely less of some goods, and they buy more when their income falls. Hence, income elasticity of demand for those goods is negative. By definition, goods with negative income elasticity are called inferior goods. Again, the word inferior means nothing other than that the income elasticity of demand for that good is observed to be negative. It does not necessarily indicate anything at all about the quality of that good. Typical examples of inferior goods might be rice, potatoes, or less expensive cuts of meat. One study found that income elasticity of demand for beer is slightly negative, whereas income elasticity of demand for wine is significantly positive. An economist would therefore say that beer is inferior whereas wine is normal. Ultimately, whether a good is called inferior or normal is simply a matter of empirical statistical analysis. And a good could be normal for one income group and inferior for another income group. (A BMW 3-series automobile might very well be normal for a moderate-income group but inferior for a high-income group of consumers. As their respective income levels rose, the moderate group might purchase more BMWs whereas the upper-income group might buy fewer 3-series as they traded up to a 5- or 7-series.) Clearly, for some goods and some ranges of income, consumer income might not have an impact on purchase decision at all. Hence for those goods, income elasticity of demand is zero.
Thinking back to our discussion of the demand curve, recall that we invoked the assumption of “holding all other things constant” when we plotted the relationship between price and quantity demanded. One of the variables we held constant was consumer income. If income were to change, obviously the whole curve would shift one way or the other. For normal goods, a rise in income would shift the entire demand curve upward and to the right, resulting in an increase in demand. If the good were inferior, however, a rise in income would result in a downward and leftward shift in the entire demand curve.