Income Elasticity of Demand (Cambridge (CIE) A Level Business): Revision Note

The concept of income elasticity of demand

• Income elasticity of demand (YED) measures the responsiveness of demand for a product to a change in income levels

  • Businesses are interested in how much the quantity demanded will change for different products

• When household incomes change, spending on goods and services will either increase or decrease, depending on the type of good or service it is

  • Normal good: A good where demand rises when income increases, e.g. restaurant meals or new clothes

  • Inferior good: A good where demand falls when income increases, e.g. instant noodles or bus travel

  • Luxury good: A good where demand increases more than proportionally as income increases, e.g. designer handbags or sports cars

Calculating and interpreting income elasticity of demand

• The YED value can be positive or negative, and the value is important in determining the type of good

  • A good with a positive YED value is considered to be a normal good

    • Normal goods can be classified as necessities or luxuries

  • A good with a negative YED value is considered to be an inferior good

• YED is calculated using the formula

Influences on YED

• YED is influenced by many factors in an economy that change the wages of workers

  • During a recession, wages usually fall and demand for inferior goods rises while demand for luxury goods falls

  • During a period of economic growth and rising wages, demand for luxury goods increases while demand for inferior goods decreases

  • Other influences on income include minimum wage legislation, taxation and increased international trade

• Understanding the income elasticity of demand is useful to businesses, as it can help them plan their production and products

  • Planning in this way will help them generate higher profits and be less exposed to economic downturns

Interpreting YED values

YED is more than 1 and positive

• Normal good

  • Examples: cars, foreign holidays, cinema visits and branded goods

  • Demand rises when income rises

  • Demand falls when income falls

  • Demand is responsive to a change in income (income elastic)

YED is between 0 and 1 and positive

• Necessity good

  • Examples: bread, milk, fuel, toothpaste

  • Demand rises slightly as income rises

  • Demand falls slightly as incomes fall

  • Demand is not very responsive to a change in income (income inelastic)

YED is negative

• Inferior good

  • Examples: public transport, domestic holidays, canned foods, own-label goods

  • Demand rises when income falls

  • Demand falls when income rises

  • Negative income elasticity

The impact of income elasticity of demand on decisions

Pricing and promotion

• Firms can anticipate changes in demand when incomes rise or fall:

  • Products with high positive YED (luxury goods) will see demand increase more than proportionally as income rises

  • During a downturn, demand for such products may fall sharply, so businesses may need to lower prices or offer discounts

  • For necessities (low YED, close to zero), demand is less sensitive to income, so businesses can maintain prices even in economic downturns

Product and capacity planning

• Positive income elasticity signals a non-necessity or luxury item, where sales rise as incomes rise

  • Burberry enjoys strong growth when wages improve, so the firm expands its high‑end ranges and store space

• Negative income elasticity identifies inferior goods

  • Supermarket "value" noodles sold more during the 2022–23 cost‑of‑living squeeze, so factories increased night shifts to cope

  • Oatly’s premium oat milk drink saw fast UK sales growth as incomes recovered in 2024, so the brand invested in a new Peterborough packing facility

Marketing objectives

• Firms set objectives using elasticity estimates

  • B&Q identified that spending on DIY products is income elastic, so it continued to add products to its portfolio during the recent economic downturn

Inventory and production schedules

• Knowing that Pumpkin Spice Lattes have a high positive PED but a strong seasonal YED, Starbucks launches them every August and adjusts its coffee bean orders months ahead

Risk management

• Airlines such as Ryanair use dynamic pricing models built on PED estimates

  • If a flight is 80% full, prices rise sharply because late bookers are less price‑sensitive 

Limitations of income elasticity of demand

• Income elasticity of demand helps businesses understand if their product is a luxury, necessity or inferior good

• However, just like with PED, there are limits to how useful YED is when making business decisions

Key limitations of YED

• Income changes are hard to predict

  • It’s difficult to know exactly when or how much people’s income will rise or fall

    • E.g. A sudden cost-of-living crisis could reduce incomes and demand for luxury items faster than expected

• Different customer groups react differently

  • Not everyone’s income changes in the same way, so demand might not shift evenly

    • E.g. A business may target high earners, but average YED data includes lower-income groups too

• Assumes income is the only factor

  • YED focuses on income changes but ignores other factors like trends, advertising or substitutes

    • E.g. A healthy food company may see demand rise due to a trend, not just because incomes have increased

• Product classification can change over time

  • A product that is seen as a luxury today might become a necessity tomorrow

    • E.g. Smartphones were once luxuries, but now they are widely considered to be essential

• Short-term versus long-term effects

  • Demand might react slowly to income changes, especially if customers delay spending

    • E.g. After getting a pay rise, an individual may not upgrade their car straight away