Income elasticity of demand is a term used to describe the amount of influence a change in income will have on consumer demand for specified goods or services. The idea is to measure the impact that an increase or decrease in income will have on the buying habits of consumers. This type of assessment is very important to companies that produce goods and services that are not considered necessities, and often is considered when setting prices for those products.
One of the assumptions that serves as the foundation for income elasticity of demand is that a shift in income level will cause a typical household to alter its purchasing habits. The general expectation when that income level is lowered for some reason is that the household will continue to purchase necessities, even though those items now consume a larger percentage of the available income. At the same time, a household that experiences a significant increase in income is likely to increase more products that are considered luxuries, while maintaining the same level of demand for necessities.
Businesses of all sizes utilize the concept of income elasticity of demand to determine how consumers are likely to respond in terms of demand for their products when some type of income shift takes place. For example, a local bookstore will likely determine that if the local economy experiences a downturn and households have less disposable income for items they want but don’t necessarily need, the sales of books will decline. In like manner, a nationwide manufacturer of frozen pizzas may find that when income levels drop, consumers increase their purchase of the product, substituting the less expensive frozen pizza for the costlier night out at a pizzeria.
Measuring income elasticity of demand can also help businesses that produce luxury or nonessential products to prepare for economic downturns by lowering prices or implementing other strategies that motivate consumers to maintain the demand for those products. Often, this involves advertising that demonstrates how the purchase of those products is more cost-effective than similar options, and how consumers will actually save money by continuing to buy those products. While this type of approach does sometimes reduce the amount of profit earned from each unit sold, businesses who monitor income elasticity of demand closely often find that monitoring consumer shifts in demand and taking action to make the most of those shifts can mean the difference between remaining in operation and shutting down forever.