Price and Income Elasticity of Demand
Price elasticity of demand (PED) measures how responsive the quantity demanded of a product is to a change in its price, calculated as the percentage change in quantity demanded divided by the percentage change in price. Demand is described as price elastic when the ignoring-sign value of PED is greater than 1 (quantity demanded changes proportionally more than price), and price inelastic when it is between 0 and 1 (quantity demanded changes proportionally less than price). Key determinants include the number and closeness of substitutes, whether the product is a necessity or a luxury, the proportion of income the product takes up, brand loyalty or addictiveness, and the time period allowed for consumers to adjust. Income elasticity of demand (YED) measures how responsive demand is to a change in consumer income instead of price; a positive YED identifies a normal good (demand rises as income rises), while a negative YED identifies an inferior good (demand falls as income rises); normal goods are further split into necessities (YED between 0 and 1) and luxuries (YED greater than 1).
Before you start
Make sure you're comfortable with these topics first:
Method
- Identify which elasticity is being asked for: PED links quantity demanded to a change in price; YED links quantity demanded to a change in income.
- Calculate the percentage change in quantity demanded: (change in quantity / original quantity) x 100.
- Calculate the percentage change in the price or income variable in the same way.
- Divide the percentage change in quantity demanded by the percentage change in price (for PED) or income (for YED), keeping the sign for YED but usually quoting PED as a size (ignoring the negative sign that price and quantity move in opposite directions).
- Classify the result: for PED, greater than 1 is elastic, between 0 and 1 is inelastic; for YED, positive means normal (further split into necessity, 0 to 1, or luxury, above 1), negative means inferior.
- Link the classification to a business decision: elastic demand means cutting price raises total revenue (and raising price cuts it), while inelastic demand means raising price raises total revenue; a positive YED tells a business to expect sales to grow in a boom, a negative YED tells it to expect sales to grow in a recession.
Worked example
A business raises the price of a product from 10 pounds to 12 pounds. As a result, weekly quantity demanded falls from 500 units to 300 units. Calculate the price elasticity of demand and state what happens to total revenue as a result of the price rise.
- Percentage change in price: (12 - 10) / 10 x 100 = 20%.
- Percentage change in quantity demanded: (300 - 500) / 500 x 100 = -40%.
- PED = percentage change in quantity demanded / percentage change in price = -40 / 20 = -2.
- Ignoring the sign, the size of PED is 2, which is greater than 1, so demand is price elastic.
- Total revenue before the price rise: 10 x 500 = 5,000 pounds. Total revenue after the price rise: 12 x 300 = 3,600 pounds.
- Revenue has fallen from 5,000 to 3,600 pounds, which is exactly what elastic demand predicts: because quantity demanded fell proportionally more than price rose, raising the price reduced total revenue.
Practice questions
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Q1State the formula for price elasticity of demand.Show answer
Answer: PED = percentage change in quantity demanded / percentage change in price.
Q2A product has a PED of -0.4. Is demand elastic or inelastic?Show answer
Answer: Inelastic, because the size of PED (0.4) is less than 1.
Q3Give one factor that makes demand for a product more price inelastic.Show answer
Answer: Having few or no close substitutes (or being addictive/a necessity, or taking up a small proportion of income).
Q4A product's price falls by 10% and quantity demanded rises by 25%. Calculate PED.Show answer
Answer: PED = 25 / -10 = -2.5, so demand is price elastic.
Q5A good has a YED of -1.2. What type of good is this?Show answer
Answer: An inferior good, because YED is negative, meaning demand falls as income rises.
Q6Explain why a business selling a product with inelastic demand might choose to raise its price.Show answer
Answer: Because when demand is inelastic, quantity demanded falls proportionally less than the price rises, so total revenue (price x quantity) increases overall despite selling fewer units.
Exam-style questions
Written in the style of a A Level Business exam paper, with a full mark scheme.
Analyse how knowledge of price elasticity of demand can help a business set its pricing strategy.
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BrightBrew is a UK coffee shop chain. Last month it raised the price of its regular filter coffee from 2.50 pounds to 3.00 pounds, and weekly sales fell from 8,000 cups to 6,000 cups. In the same month, its espresso-based specialty drinks (average price 4.50 pounds) saw demand rise by 15% when local average household income rose by 10%. Using the data, evaluate whether BrightBrew should raise the price of its filter coffee further.
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