Income Elasticity of Demand versus Consumption: Implications for Energy Policy Analysis

Abstract

The income elasticity of consumption depends not only on the demand function but also on the characteristics of the supply function. If the supply of the underlying good (e.g., gasoline, natural gas, or housing) is not completely elastic, the income elasticity of equilibrium consumption will be less than the income elasticity of demand, with the difference depending on the shapes of both the demand and supply functions. We show that if supply is sufficiently inelastic, extending the individual-level estimates of the income elasticity of demand to aggregate values can produce biased estimates with erroneous and misleading policy implications, even if the original elasticity estimate was unbiased. This point is particularly important when extrapolating the impact of national income on aggregate emissions.

Keywords: Supply Elasticity, Demand Elasticity, Income Elasticity, Income-Emission Relationship, Engel Curve

JEL Classification: C23, F15, H77, Q41