Explain the concept of income elasticity of demand. How is it used to identify normal goods, luxuries, necessities, and inferior goods? Be as specific and logical as possible.
Income elasticity of demand measures the responsiveness of demand to a change in income. Depending on the value of the income elasticity coefficient products are divided into normal goods, luxuries, necessities, and inferior goods.
If a good has a negative income elasticity coefficient, it is an inferior good. It means an increase in income causes a fall in demand, because the consumer switches to another good that can replace this product satisfying the same need (as a rule, it is better and more expensive products). For example, consumers will reduce purchases of cheap cheese and increase purchases more expensive and delicious.
If a good has a positive income elasticity coefficient, it is normal good. But, a normal good can be income elastic or income inelastic. If a good has income elasticity coefficient between zero and one (it is income inelastic), it is a necessity good. The increase for a necessity good is less than proportional to the rise in income, so the proportion of expenditure on these goods falls as income rises. Necessity goods are goods that we cannot live without and will not likely cut back on even when times are tough, for example food, power, water and gas.
If a good has income elasticity coefficient above 1 (it is income elastic), it is a luxury. A luxury good means an increase in income causes a bigger % increase in demand (expensive clothes for example).