Economic Income Elasticity

Income elasticity is a term used in economics that refers to changes in demand for goods and services in relation to per capita income i.e. decreases or increases in the spending power and/or income levels in a population.(1) This article will discuss both the concept of income elasticity, how it is calculated and provide examples of calculation. 

It will then relate income elasticity to implications on consumer and/or personal spending in addition to discussing deficiency in the income elasticity formula. Moreover, since income elasticity is not an isolated set of variables, i.e. it is not mutually exclusive to other economic factors, income elasticity measurements may not be as revealing of underlying causes and changes in income and demand as they could be.

• Income elasticity and demand

Income elasticity and demand is measured by simply dividing the percentage change in aggregate goods and services demanded for a specific period by the percentage change in total national income for the same time period.(1) For example, if the total amount of gasoline sold in a country increases %10 for 1 year and the net income of a population increases by %8 for that same year, the income elasticity would be calculated by dividing 10% by 8% which is equal 1.25.

The percentage change in income itself is determined by dividing the change in income by the pre-existing income level.(2) For example, if new per capita income is $32,400.00 and pre-existing income is $30,000.00, the percentage change is $2,400.00 divided by $30,000.00 for a change of 8%. The same formula can be used to determine the percentage change in demand.

The higher the income elasticity result is, the greater demand for goods and/or services also is. In other words, if percentage change in demand increases a lot for a relatively small percentage change in income, the income elasticity is said to be elastic. However, if demand changes little in comparison to larger changes in income, the income elasticity is inelastic, meaning demand is less affected by significant changes to income. An example of products more likely to have inelastic demand is high priced items such as surgery or very expensive vacation tours.

• Analysis of the income elasticity calculation

Income elasticity in and of itself may not indicate why changes in demand are either elastic or inelastic. This is because factors such as inflation may reduce the spending power of an increased income making the demand for goods change less had inflation not occurred. For example, if the value of a currency and/or its spending power decreases by 3% and national per capital income rises 4%, the net rise in income is in effect, only 1%. This 1% rise in real income may subsequently lead to a lower change in demand than had no inflation occurred.

Additionally, an increase in the workforce can also influence aggregate income information in the following way. If a population of 1 million people has an average per capita income of $35,000.00/year and this initial population experiences a percentage rise in income of 5%, but 100, 000 new workers enters the workforce at an average income of $33,000.00/year, the net change income will be less than 5% because of the increase in the workforce.

To illustrate the above, the initial population has an increase of income of $1,750.00 to $36,750.00/year or 5% but the 100, 000 new workers earning $33, 000.00/year are also incorporated into the next income calculation the recorded income increase will be less than 5%. Specifically, using a weighted average calculation, $33,000.00/year times 9.09% i.e. the percentage of the new population that the 100, 000 new workers represent, plus $36,750.00/year times 90.9% i.e. the percentage of the original population with an average income increase, is equal to $3000.00+$33,406.00=$36,405.00 which is less than the increase to the original populations income increase by approximately 1% less.

What this means for income elasticity is demand elasticity may be over estimated by an increase in demand that includes 100, 000 new income earners making the elasticity measurement too high. Thus, for income elasticity measurements to be accurate, the changes in population and inflation should ideally be incorporated into the income elasticity calculation. This can be done by performing separate income elasticity calculations for the two population groups, then comparing those calculations to the original income elasticity results.

To illustrate the above, if income elasticity is 4 for the original population, and 2 for the 100, 000 new workers, the elasticity is more accurately measured in terms of income for the two groups separately, and indicates an increase in demand (and not necessarily elasticity) despite a lower average income for the 100, 000 new workers. In other words, basic income elasticity calculations do not account for changes in demand caused by increases in a population's consumer needs.

Summary:

Income elasticity is a basic economic principle that attempts to measure changes in demand for goods and/or services in terms of consumer income. The formula for calculating income elasticity is fairly straightforward however does not take into account other important economic factors such as the impact of inflation and population growth within a workforce on elasticity. 

For this reason, income elasticity calculations should be taken with a grain of salt i.e. not taken literally for the formula does not account for increases in demand caused by a greater number of consumers. That is to say, income elasticity may be overestimated due to population growth and inflation. This article has discussed the concept of income elasticity, illustrated its calculation and elaborated on its meaning and implications on demand for goods and services.

Sources:

1. http://bit.ly/9332bT (Investopedia)
2. http://bit.ly/9rau9L (MoneyTerms)
3. http://bit.ly/c2NGOD (Investopedia, economics)
4. http://bit.ly/9x7F95 (Investopedia, Inelasticity)