An Insight into 7 Factors Affecting Income Elasticity of Demand

Factors Affecting Income Elasticity of Demand - Wallet

You’ll agree that income levels influence consumer buying patterns. In essence, the higher the income levels, the greater their buying powers. But in business circles though, high income does not always translate to increased spending as there are many other factors that influence income elasticity of demand.

As an entrepreneur, then, it’s important to have a grasp of how changes in income impact on consumer buying decisions. It not only helps you adjust your pricing metrics but also device winning marketing blueprints.

In this layman’s guide, we delve into the topic of income elasticity of demand and list 7 critical factors that influence consumer demand even with the changing incomes.

Income elasticity of demand (YED) is a representative ratio of change in consumer demand to net changes in consumers’ real incomes. In essence, it’s a measure of how responsive a market becomes after changes in income levels of people buying the goods or services.

The 5 types of income elasticity of demand.

  1. High-income elasticity of demand.

    If the net change in demand exceeds the net change in real incomes such that the YED is greater than one, then this is a high-income elasticity of demand. This kind of YED is often seen in luxury goods’ markets such as jewelry and luxury cars for example.

  2. Unitary income elasticity of demand.

    An increase in real incomes whips a proportional rise in demand for goods on offer. This means YED= 1. This position is often evident in the purchasing of normal goods such as food, clothing, and entertainment.

  3. Low-income elasticity of demand.

    Demand for certain types of goods only changes marginally even when there’s a huge change in income levels of buyers. The resultant YED has a range of between zero and one.

  4. Zero income elasticity of demand.

    Demand for some goods such as household salt doesn’t change even with large changes in incomes. Such goods have a zero YED.

  5. Negative income elasticity of demand.

    Suppose you received a significant salary increase, would you continue purchasing inferior products? Most likely not; Goods whose YED is less than zero are said to have a negative income elasticity of demand.

How to calculate YED:

As already expressed, YED is a ratio of demand changes to income changes. Both values are expressed in percentages;

Factors Affecting Income Elasticity of Demand YED

As an example. if income goes up by 5% in a year and the demand for new cars goes up by 10% then the YED is 2.0. To arrive at that number you simply divide 10 by 5. That is a positive number for people who are in the car dealership industry. It means that there is a high demand for new cars compared to growth in income.

However, if the demand for used cars falls by 20% following an increase in income of 5%. That would be -20% divide by 5% which equals -4%. People in the used car industry would experience a drop in sales.

Let’s look at some of the 7 factors that influence income elasticity of demand.

  1. Nature of product on sale.

    As already seen above, certain kinds of goods have high YED as they are considered items of status. These include luxury assets such as jewelry and cars.

    Other goods either experience a marginal change while others undergo a negative change in YED. In essence, elasticity is dependent on the type of good and how it is used.

  2. The versatility of the goods on offer.

    If a product has alternative uses, then consumers will most likely go for it after a salary increment. This is because they have the means to buy the product and they can also use it to replace other items.

    This leads to increased demand for certain types of goods upon an increase in income. This may not be the case for the economically endowed in the society as they already have the resources to buy multiple items without feeling the pinch in their pockets.

  3. Time factor.

    Some goods take time to gain traction in the market even with an increase in income levels of the consumers. Likewise, incomes in a country may change over time such that a product that was considered a luxury at a certain point of time becomes a necessity as the economy grows.

    The goods that are being introduced into the market for the first time may start on a slow note but gain traction over time as consumers gain trust.

  4. Wealth distribution in society.

    Income influenced elasticity of demand is far higher for lower-income groups compared to those with higher levels of income.

    A salary increase among the poor will see a surge in demand for certain kinds of goods such as food items and normal clothing compared to the same salary increment for those well up in society.

  5. A country’s economic status

    An increase in incomes for a developed country may not have a profound change in demand compared to salary increment in, say, a poor, third country.

    This is because consumers in the well upcountry have had the resources to buy the basics. Consumers from the poorer country will likely use the increment to buy more basic stuff thus leading to significant changes in YED.

  6. Demonstration effect.

    Aggressive marketing of a product exposes consumers to tastes that they weren’t previously accustomed to. This especially applies to products that are best marketed through demonstrations such as mobile phones.

    Once consumers understand the functioning of such goods, they will certainly have a positive attitude and this improves the likelihood of them buying the goods. An increase in incomes will only lead to increased demand for such products.

  7. Habitual goods.

    Habitual necessities such as alcohol, cigarettes, and tobacco have a less flexible demand curve. Whether incomes increase or reduce, users continue buying and using the given products.

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Why should the knowledge of income Elasticity of Demand matter to you, the entrepreneur?

Your business is dependent on the purchasing power of your buyers. Knowing how changes in their incomes will affect your business helps you craft a contingency plan with regard to pricing your goods and services.

This knowledge will also help you understand your competitor’s marketing models and thus develop a counter-strategy so as to gain part of their market share.

In Summary

While the success of a business is determined by a range of factors, the buying power of a consumer is a key metric. As a buyer owner, it’s important to have some basic understanding of how changes in customers’ income can impact your business from the bottom line.

This way, you’ll be in a good position to craft a strategy that reflects your consumers existing position. It’s only then that you will be able to survive through the ever-changing business environment.

If you are running a brick and mortar business, understanding these strategies will give you a big edge in terms of growth. Those who invest their time in knowledge are the ones who are most likely to succeed.  If you are just testing the waters of the business world, its best to start with baby steps.

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Many thanks for reading my post. If you have a question or a comment on factors affecting income elasticity of demand, please leave it below. I would love to hear from you.

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