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Price Elasticity of Demand: Determinants and Business Applications

Method

State the YED formula and calculate percentage changes for both quantity demanded and income before dividing.
Interpret the sign of YED: positive means a normal good, negative means an inferior good; interpret the size for normal goods, 0 to 1 is a necessity, above 1 is a luxury.
Learn examples appropriate to each category: necessities, e.g. basic foodstuffs, luxuries, e.g. foreign holidays or premium cars, and inferior goods, e.g. value-brand supermarket products.
State the XED formula and calculate percentage changes for the quantity demanded of good A and the price of good B before dividing.
Interpret the sign of XED: positive means substitutes, a rise in the price of B makes consumers switch towards A, and negative means complements, goods used together, and interpret the size as the strength of the relationship.
Apply YED to business strategy, e.g. producers of income-elastic luxury goods gain disproportionately in a boom but lose disproportionately in a recession, and to government forecasting of sector growth.
Apply XED to business pricing decisions for goods with close substitutes or complements, e.g. a games console firm pricing the console low, knowing XED with its own games is strongly negative, profiting instead on game sales.

Worked example

Average consumer income rises by 5%, and demand for foreign holidays rises by 12%, while demand for value-brand tinned beans falls by 2%. Calculate the income elasticity of demand for each good and classify each good (normal/inferior, and luxury/necessity where relevant).

Calculate YED for foreign holidays: YED = percentage change in quantity demanded / percentage change in income = 12% / 5% = 2.4.
Interpret: YED is positive (2.4), so foreign holidays are a normal good; since 2.4 is greater than 1, they are also income elastic, i.e. a luxury good.
Calculate YED for value-brand tinned beans: YED = -2% / 5% = -0.4.
Interpret: YED is negative (-0.4), so value-brand tinned beans are an inferior good, as income rises, demand for them falls, likely because consumers switch to named-brand alternatives.
Compare the two: foreign holidays (YED = 2.4) are far more responsive to income changes than tinned beans (YED = -0.4), meaning holiday demand will swing much more sharply over the economic cycle.

Practice questions

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Q1State the formula for income elasticity of demand (YED).Show answer

Answer: YED = percentage change in quantity demanded / percentage change in income.

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Q2What does a negative YED indicate about a good?Show answer

Answer: That it is an inferior good - demand for it falls as consumer income rises.

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Q3A good has a YED of 0.6. Classify this good.Show answer

Answer: It is a normal good (positive YED) and a necessity (income inelastic, since YED is between 0 and 1).

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Q4State the formula for cross elasticity of demand (XED).Show answer

Answer: XED = percentage change in quantity demanded of good A / percentage change in price of good B.

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Q5What does a positive XED indicate about the relationship between two goods?Show answer

Answer: That the two goods are substitutes - a rise in the price of one causes consumers to switch to and buy more of the other.

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Q6What does a negative XED indicate?Show answer

Answer: That the two goods are complements - they tend to be consumed together, so a rise in the price of one reduces demand for both.

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Q7The price of coffee rises by 10% and demand for tea rises by 4%. Calculate the XED between tea and coffee and state whether they are substitutes or complements.Show answer

Answer: XED = 4% / 10% = 0.4. Since XED is positive, tea and coffee are substitutes.

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Exam-style questions

Written in the style of a A Level Economics exam paper, with a full mark scheme.

Q1[5 marks]

During an economic downturn, average consumer income falls by 6%. Demand for a value-brand supermarket range rises by 3%. Calculate the YED for this product range and explain what this figure suggests about the type of good it is.

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correct calculation, YED = 3% / -6% = -0.51 mark
correct sign interpretation, income fell while demand rose, giving a negative YED1 mark
correctly identifies the good as an inferior good1 mark
explains the mechanism, as income falls consumers trade down from named brands to cheaper value-brand alternatives1 mark
notes the size (0.5, less than 1 in absolute terms) shows demand is income inelastic even though it is inferior1 mark

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Q2[12 marks]

Evaluate the usefulness of income elasticity of demand (YED) for a firm deciding which products to focus on in the run-up to an expected economic recession.

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Tick each line you got. Your score builds from the marks on the scheme.

basic, undeveloped assertion, e.g. sell cheap stuff in a recession, with little reference to YED.2 marks
one or more developed chains applying the sign/size of YED to the recession scenario, but one-sided or with limited evaluation.2 marks
balanced chains plus a supported judgement on usefulness.2 marks
Specific content: chain (useful) - a firm can use estimated YED figures to identify which products are luxuries and which are inferior or necessities; in an expected recession, demand for luxuries will fall disproportionately while demand for inferior goods may rise, so resources can shift ahead of the downturn.1 mark
Specific content: chain (useful) - a diversified firm holding both luxury and inferior/necessity product lines can use YED data to manage risk across the economic cycle.1 mark
Specific content: chain (limitation) - YED estimates are based on historical data and assume other factors stay constant, but a recession often coincides with other changes, e.g. rising unemployment or falling confidence, that affect demand independently.1 mark
Specific content: chain (limitation) - YED can vary between different types of recession and between different consumer segments, so a single average figure may mask very different responses among the firm's customers.1 mark
Specific content: evaluation - usefulness depends on how reliable and recent the underlying data is, on how severe and long the expected recession is forecast to be, and on whether the firm can act on the information quickly enough.1 mark
Specific content: judgement - a supported conclusion that YED is a useful strategic signal for resource allocation ahead of a downturn, but should be one input among several rather than the sole basis for the decision.1 mark

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Income and Cross Elasticities of Demand

Before you start

Method

Worked example

Practice questions

Exam-style questions

Free printable worksheet

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