Applying YED — Demand and Rising Income

Idea

Income elasticity of demand governs how a good’s demand responds when consumer income changes. As income rises, the demand curve shifts by an amount and direction set by the good’s YED.

Diagram

Mechanism

When income rises, with

$YED = \frac{\%\,\text{change in quantity demanded}}{\%\,\text{change in income}}$

• Luxury goods ($YED > 1$): demand rises more than proportionately — high-end clothing, a 10% income rise prompting perhaps a 25% demand rise. Demand shifts right strongly to D_lux.

• Necessities ($0 < YED < 1$): demand rises less than proportionately — rice and water, a 10% income rise prompting perhaps a 2% demand rise. Demand shifts right weakly to D_n.

• Inferior goods ($YED < 0$): demand falls as consumers switch up to normal and luxury goods — hawker meals or second-hand furniture given up as income grows. Demand shifts left to D_in.

Considerations

Two determinants set a good’s YED:

• Nature of the good — whether it is a necessity, a luxury, or an inferior good, which fixes the sign and band of YED.

• Income level — the same good can be a luxury at low incomes and an inferior good at high incomes (a condominium for a working-class family versus a high earner who can afford landed property), so YED depends heavily on the affluence of the economy.

For evaluation, YED predicts how producers and policymakers should expect demand to evolve as an economy grows — which industries expand, and which decline.