Just by the name, we know this elasticity is about two very specific variables: Income and Demand. Specifically, we compare the percentage change in income to the percentage change in quantity demanded it caused:
Income Elasticity of Demand
% Change in Quantity Demanded
____________________________
% Change in Income
Sign is Everything!
When calculating the Income Elasticity of Demand, and unlike when we calculate the Price Elasticity of Demand, we care greatly about the sign.
Suppose we’re analyzing the effect of a 10% increase in income on consumption of a good. Nice… more moolah is always better than less moolah, but I digress…
One of two things can happen: either consumers want more of the good or consumers want less of the good.
Normal Good
If the good is normal, like eating out at nice restaurants, consumers will buy more of it as their income rises; we represent this by a rightward shift of the Demand curve.
Think about it. When our incomes rise, we eat out at nice places more often. Ah, the life…
There is a positive relationship here: more income, more consumption, so the elasticity is going to be positive as well:
Normal Good
More Income, Greater Demand
Income Elasticity of Demand > 0
Naturally, this positive relationship between income and Demand occurs when income decreases as well. When our incomes fall, we eat out at nice places less often. Less income, less consumption. Life is a bit sadden then.
Inferior Good
If the good is inferior, like eating out at fast-food outlets, consumers will buy less of it as their income rises; we represent this by a leftward shift of the Demand curve
Think about it. When our income rise, we eat out at this type of places less often. We are going to the nice restaurants instead, right? We lower our consumption of inferior goods and boost our consumption of normal goods.
There is a negative relationship here: more income, less consumption, so the elasticity is going to be negative as well:
Inferior Good
More Income & Smaller Demand
Income Elasticity of Demand < 0
Naturally, this negative relationship between income and Demand occurs when income decreases as well. When our incomes fall, if we really have our minds set on eating out, we do so at fast-food outlets, which are cheap. Less income, more consumption. Not healthy, though.
FYI, this happened during the great recession, and fast-food outlets saw an increase in sales: as people feel poorer, they increased their Demand for inferior goods. Read the Financial Times’ Recession Sees Growth in Fast-Food Outlets to learn more.
Sign is Blah (shrugs) on Price Elasticity of Demand
When calculating the Income Elasticity of Demand, as well as when calculating the Cross-Price Elasticity (of Demand), sign matters greatly. This is unlike when we calculate the Price Elasticity of Demand.
Indeed, when calculating the Price Elasticity of Demand, we make our lives simpler by taking the absolute value of the ratio of the percentage change in quantity demanded to the percentage change in price. The reasons why the sign of the Price Elasticity of Demand does not matter are two-fold. First, the Law of Demand tells us quantity demanded and price always react negatively, so the ratio is inevitably negative. Second, when we use the mid-point method, the percentage variations are independent of whether the variable increased or decreased, so the elasticity is the same regardless of whether the price increased or decreased.
On the contrary, the sign of the Income Elasticity of Demand has meaning: regardless of whether income increased or decreased, a positive sign tells us the good is normal whereas a negative sign tells us the good is inferior.
Joana Girante 