Step ➊ : Define 'income elasticity of demand' in the introduction


Income elasticity of demand can be used to distinguish between inferior goods and necessary goods. Income elasticity of demand (YED) is defined as a numerical measure of the responsiveness of the quantity demanded following a change in income, all other factors remain unchanged.

The formula for income elasticity of demand is as follows :

YED =

% change in quantity demanded
─
% change in income


Step ➋ : Explain the difference between necessary goods and inferior goods.

Necessary goods are products and services that consumers will buy regardless of the changes in their income levels, therefore making these products less sensitive to income change. A necessary good is a type of normal good. Since an increase in income leads to an increase in the quantity demanded for the good, there is a positive relationship and the good is classified as normal. The YED has a positive value. Items such as Staple food products such as bread and vegetables are necessity goods as they have a low income elasticity of demand.

On the other hand, inferior goods, exhibit a negative relationship between income and demand. The YED of an inferior good has a negative value. For example, a person on low income may buy cheap margarine, but, when his income rises, he will afford better quality foods, such as Cheddar.


Step ➌ : Explain how income elasticity of demand differ between necessity goods and inferior goods.


➤ 3.1 Necessary goods have an income elasticity of demand of between 0 and +1. For example, if income increases by 10% and the demand for fresh fruit increases by 4% then the income elasticity is +0.4. As income rises, the demand for necessity goods rises only a little. Demand is rising less than proportionately to income.

➤ 3.2 Inferior goods have a negative income elasticity of demand. This means that the demand for the good decreases as people’s incomes rise beyond a certain level. An example of an inferior good is cheap margarine. As people earn more, so they switch to butter or better quality margarine.

The following diagrams show the relationship between the average income earned and the quantity demanded for both types of good.

In the first diagram, an increase in income, from Y1 to Y2, leads to a less than proportionate increase in quantity demanded for the necessity good, from Q1 to Q2.

In the second diagram, an increase in income, from Y1 to Y2, leads to a decrease in quantity demanded for the inferior good, from Q1 to Q2.