The meaning and calculation of price elasticity of demand

Price elasticity of demand (PED) measures how much the quantity demanded of a product changes in response to a change in its price.

Formula for price elasticity of demand

$\text{Price elasticity of demand (PED)}=\frac{\text{\% change in quantity demanded}}{\text{\% change in price}}$

PED values are always negative. When interpreting these values, ignore the negative sign.

Interpreting PED values

• Price elastic demand - PED > 1 (ignoring the minus sign). The percentage change in quantity demanded is greater than the percentage change in price.
• Price inelastic demand - PED < 1 (ignoring the minus sign). The percentage change in quantity demanded is less than the percentage change in price.

Demand curve shapes based on PED

• Price elastic products have shallow (flatter) demand curves.
• Price inelastic products have steep demand curves.

Worked example - Calculating price elasticity of demand

A company increases the price of its headphones from £60 to £75, resulting in quantity demanded falling from 800 units to 600 units per month. Calculate the PED.

Step 1: Identify the values

• Original price = £60
• New price = £75
• Original quantity demanded = 800 units
• New quantity demanded = 600 units

Step 2: Calculate the percentage changes

% change in price = ( (£75 - £60) / £60 ) × 100 = 25%

% change in quantity demanded = ( (600 - 800) / 800 ) × 100 = -25%

Step 3: Apply the PED formula

$\text{PED}=\frac{-25\%}{25\%}=-1$

Step 4: Interpretation

Ignoring the minus sign, PED = 1, meaning the percentage change in quantity demanded equals the percentage change in price.

Factors influencing price elasticity of demand

Several factors determine whether demand for a product is price elastic or inelastic.

Key factors affecting PED

• Necessity of the product - Essential items tend to be price inelastic as price changes do not greatly affect demand.
• Availability of substitutes - If close alternatives exist, demand is more price elastic because consumers can switch easily. For instance, if one brand of tea raises its price, buyers might choose a rival brand.
• Brand loyalty - Strong attachment to a brand makes demand less price elastic.
• Time period - PED increases over time as consumers have more opportunity to find alternatives.
• Access to information - The internet makes it easier to compare options, increasing price elasticity.
• Product category vs. individual brands - Broad categories tend to be inelastic, while specific brands within them are elastic.
• Proportion of income:
  • Items that take up a large share of income are more price elastic.
  • For example, a 10% price rise in sugar might not affect demand much, but the same rise for a laptop could lead consumers to delay purchase or seek deals.
• Purchase frequency - Frequently bought items tend to be price inelastic.
• Competitor entry - New rivals entering the market make demand more price elastic.
• Brand awareness - High recognition can make products less price elastic.

The impact of price elasticity on revenue

Sales revenue is calculated as selling price multiplied by sales volume. PED directly affects how price changes influence a business's total revenue.

Formula for sales revenue

$\text{Sales revenue}=\text{selling price}\times \text{sales volume}$

Effects of price changes on revenue

• For price elastic products (PED > 1):
  • Increasing price reduces revenue.
  • Decreasing price increases revenue.
• For price inelastic products (PED < 1):
  • Increasing price increases revenue.
  • Decreasing price decreases revenue.

The meaning and calculation of income elasticity of demand

Income elasticity of demand (YED) measures how much the quantity demanded of a product changes in response to a change in consumers' income.

Formula for income elasticity of demand

$\text{Income elasticity of demand (YED)}=\frac{\text{\% change in quantity demanded}}{\text{\% change in income}}$

Interpreting YED values

• Normal products - Positive YED.
  • Necessity products: Positive YED < 1 (demand rises slower than income).
  • Luxury products: Positive YED > 1 (demand rises faster than income).
• Inferior products - Negative YED, meaning demand falls as income rises (and rises as income falls). For example, demand for a low-cost own-brand cereal might decrease during economic growth as consumers switch to premium options.

Worked example - Calculating income elasticity of demand

During an economic upturn, average income rises from £40,000 to £44,000 per year, and demand for a luxury watch brand increases from 750 units to 975 units per quarter. Calculate the YED.

Step 1: Identify the values

• Original income = £40,000
• New income = £44,000
• Original quantity demanded = 750 units
• New quantity demanded = 975 units

Step 2: Calculate the percentage changes

% change in income = ( (£44,000 - £40,000) / £40,000 ) × 100 = 10% % change in quantity demanded = ( (975 - 750) / 750 ) × 100 = 30%

Step 3: Apply the YED formula

$\text{YED}=\frac{30\%}{10\%}=3$

Step 4: Interpretation

YED = 3 (positive and >1), indicating a luxury product where demand rises faster than income.

How businesses use elasticity in decision-making

Elasticity provides valuable insights for pricing strategies and planning during economic fluctuations.

Using PED in pricing decisions

• For price elastic products, businesses should set low, competitive prices.
• For price inelastic products, higher prices or strategies like price skimming can be used.
• If PED is high, reducing prices can raise revenue, provided profit margins remain viable.
• If PED is low, increasing prices can raise revenue.

Using YED in economic planning

• During recessions (falling incomes), products with negative YED (inferior goods) perform better.
• During economic growth (rising incomes), products with positive YED (normal goods) see stronger demand.
• Businesses with diverse ranges can shift marketing focus: promote inferior goods in downturns and luxury items in upturns.