What it means
Everyday goods like bread, electricity and basic clothing are necessities. Demand for them stays fairly steady even if incomes change.
Luxury items behave differently, because spending on them rises faster than income when people get richer and falls faster when they get poorer. The economic measure is income elasticity of demand.
If it is above 1, the good is a luxury, which means a given percentage rise in income leads to a larger percentage rise in the quantity demanded. If it is between 0 and 1 the good is a normal necessity, and if it is negative the good is an inferior good that people buy less of as they get richer.
Luxury is relative. A smartphone might be a luxury in one country or decade and a necessity in another.
Within a single household, a meal at a fine restaurant may be a luxury while a weekly grocery shop is a necessity. For businesses, the classification shapes strategy.
Luxury brands tend to be highly exposed to the economic cycle, since customers cut back on non-essentials during downturns. They also rely on exclusivity, brand heritage and pricing power, so discounting can do lasting damage to the brand.
Governments also use the idea. Luxury items are sometimes taxed at higher rates because buyers are assumed to have a greater ability to pay, and because demand is often less responsive to price than to income.
Tax design therefore uses the luxury concept as a signal of who can afford a bill. Finally, some luxury goods show unusual behaviour known as Veblen effects, where a higher price actually makes the product more desirable as a status symbol.
This is a nuance to remember when setting prices.
In practice
Real-world examples.
Example
A car maker sees demand for its entry-level model fall during a recession by 5%, but demand for its top-end sports car fall by 30%. The finance team treats the sports car as a luxury and plans for more volatile sales.
Example
A hotel group finds that business at its five-star resorts rises sharply when stock markets boom, while its budget hotels grow slowly. Management uses this to decide where to put new capital as the economy improves.
Example
A government considers a surtax on private jets and yachts. Analysts estimate that buyers will not change their behaviour much because the cost is small relative to the purchase price, so revenue should be reasonably dependable.
Formula
Calculation
Income elasticity of demand = Percentage change in quantity demanded / Percentage change in income
Suppose household incomes in a city rise by 10%, and sales of premium watches in that city rise by 25%. Income elasticity = 25% / 10% = 2.5. Because 2.5 is greater than 1, premium watches are a luxury item in this market. In contrast, if grocery sales rose by only 3% over the same period, the elasticity would be 3% / 10% = 0.3, which indicates a necessity.Case study
Seen in the real world.
Silverbrook Leather Goods is an illustrative, fictional handbag maker with two lines, a $90 everyday range and a $1,800 collection. When incomes in its main market rose 8%, sales of the everyday range grew by 4%, but sales of the collection grew by 20%. The finance director calculated an elasticity of 0.5 for the first line and 2.5 for the second.
When the economy slowed the following year, the collection suffered most. Armed with the elasticity figures, the fictional company had already reduced its production commitments and kept a cash buffer, while a rival that had expanded aggressively was left with unsold stock. The illustrative lesson was that luxury sales rise quickly in good times and fall quickly in bad.
A second lesson came from the pricing team. When the company briefly discounted the collection to clear stock, the fictional brand found that buyers read the lower price as a drop in prestige, and the discount was withdrawn within a month.
Watch out
Common mistakes.
- Defining a luxury by price alone, when the economic test is how strongly demand responds to changes in income.
- Assuming a luxury item is always a luxury, when goods can move into necessity status as technology and incomes change.
- Treating all high-priced goods as having the same demand pattern, when status goods can behave differently from ordinary luxuries.
Questions
People also ask.
What is the opposite of a luxury item?
A necessity, which people buy regardless of income, and an inferior good, which people buy less of as they become richer, are both contrasts.
Why are luxury brands sensitive to the economy?
Their products are discretionary, so when incomes or confidence fall, customers can simply delay the purchase, and the effect shows up quickly in revenue and in factory utilisation.
What is a Veblen good?
It is a luxury whose demand rises with its price because the high price signals status, which is the opposite of how ordinary goods behave, and it means that cutting the price can reduce sales.
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