Explain the concept of income elasticity of demand.

The concept of income elasticity of demand measures the responsiveness of the quantity demanded of a good or service to changes in income. It is calculated by dividing the percentage change in quantity demanded by the percentage change in income.

Income elasticity of demand can be categorized into three types:

1. Income Elasticity of Demand > 1: When the income elasticity of demand is greater than 1, it indicates that the good or service is income elastic. This means that as income increases, the demand for the good or service increases at a proportionally higher rate. Examples of income elastic goods include luxury items, such as high-end cars or vacations.

2. Income Elasticity of Demand < 1: When the income elasticity of demand is less than 1, it indicates that the good or service is income inelastic. This means that as income increases, the demand for the good or service increases at a proportionally lower rate. Examples of income inelastic goods include essential items, such as food or utilities, where demand does not significantly change with income fluctuations.

3. Income Elasticity of Demand = 0: When the income elasticity of demand is equal to zero, it indicates that the good or service is income neutral. This means that changes in income have no effect on the demand for the good or service. Examples of income neutral goods include basic necessities, such as salt or water, where demand remains constant regardless of income changes.

Understanding income elasticity of demand is crucial for businesses and policymakers as it helps predict how changes in income levels will impact the demand for different goods and services. This information can be used to make informed decisions regarding pricing, production, and resource allocation.