Factors influencing price elasticity of demand

Price elasticity of demand (PED) measures how much the quantity demanded of a good changes in response to a change in its price. Several factors affect whether demand is elastic (PED < –1) or inelastic (–1 < PED < 0).

Influences on price elasticity of demand

• Availability of substitutes - Goods with many close substitutes have more elastic demand because consumers can easily switch if prices rise. The number of substitutes depends on how closely the good is defined.
• Type of good or service:
  • Essential items tend to have inelastic demand.
  • Non-essential items often have elastic demand.
  • Habit-forming goods usually have inelastic demand.
  • Goods that cannot be postponed have inelastic demand.
  • Versatile goods with multiple uses tend to have inelastic demand.
• Percentage of income spent on the good - Products that require a large proportion of a consumer's income have more elastic demand. Products that require a small proportion of income have inelastic demand.
• Time period - Demand becomes more elastic over time as consumers find alternatives, adjust habits, or change loyalties.

The relationship between total revenue and price elasticity of demand

Total revenue is calculated as price per unit × quantity sold. It has a direct link to PED, which varies along a straight-line demand curve. Firms can use this to decide pricing strategies that maximise revenue.

How PED changes along a demand curve

PED changes along the demand curve from highly elastic at high prices with low demand, becomes unit elastic at the midpoint, and turns inelastic at low prices with high demand. Total revenue is maximised when PED = –1, so firms aim to price near the demand curve's midpoint to achieve higher total revenue.

Effects on revenue for elastic demand

If demand is elastic (PED < –1):

• Lowering price increases total revenue.
• Raising price decreases total revenue.

Effects on revenue for inelastic demand

If demand is inelastic (–1 < PED < 0):

• Lowering price decreases total revenue.
• Raising price increases total revenue.

Worked example - Calculating revenue changes with elastic demand

A firm sells a product with an elastic PED of –2.8. At £15 per unit, it sells 30 units. If the price drops to £10, sales rise to 58 units. Calculate the initial and new total revenue.

Step 1: Identify the values

• Initial price = £15
• Initial quantity = 30 units
• New price = £10
• New quantity = 58 units

Step 2: Calculate initial total revenue

Total revenue = £15 × 30 = £450

Step 3: Calculate new total revenue

Total revenue = £10 × 58 = £580

Step 4: Interpretation

The price reduction increases total revenue from £450 to £580, as expected with elastic demand.

Worked example - Calculating revenue changes with inelastic demand

A firm sells a product with an inelastic PED of –0.6. At £20 per unit, it sells 25 units. If the price drops to £16, sales rise to 28 units. Calculate the initial and new total revenue.

Step 1: Identify the values

• Initial price = £20
• Initial quantity = 25 units
• New price = £16
• New quantity = 28 units

Step 2: Calculate initial total revenue

Total revenue = £20 × 25 = £500

Step 3: Calculate new total revenue

Total revenue = £16 × 28 = £448

Step 4: Interpretation

The price reduction decreases total revenue from £500 to £448, as expected with inelastic demand.

Income elasticity of demand for normal and inferior goods

Income elasticity of demand (YED) measures how quantity demanded changes with income. It varies by good type, helping firms predict demand during economic changes.

Normal goods

Normal goods have positive YED (YED > 0), meaning demand rises as income increases. If the YED of a product is elastic (YED > 1), it is considered a luxury or superior good.

Inferior goods

Inferior goods have negative YED (YED < 0), meaning demand falls as income rises.

Cross elasticity of demand for substitutes, complements, and independent goods

Cross elasticity of demand (XED) measures how quantity demanded of one good changes with the price of another. It indicates relationships between goods.

Substitute goods

Substitutes have positive XED (XED > 0), so a price fall in one reduces demand for the other. The closer the substitutes, the higher the positive XED.

Complementary goods

Complements have negative XED (XED < 0), so a price rise in one reduces demand for the other.

Independent goods

Independent goods have XED = 0, meaning price changes in one do not affect demand for the other.

Uses of elasticities of demand for firms and governments

Knowledge of PED, YED, and XED helps firms and governments make informed decisions, forecast changes, and set policies.

Applications for firms

• Sales forecasting with YED - Firms can predict sales levels based on the YED of a product and expected changes in income.
• Pricing policies with YED - A firm might reduce the price of a normal good during an expected fall in incomes to limit the reduction in demand.
• Product diversification with YED - Firms may supply a range of goods with various YEDs to maintain revenue during economic fluctuations, such as providing products with low YED during recessions.
• Responding to competitors with XED - Firms can use XED to react to changes in the price of related products to maximise demand. For example, if a close substitute's price drops, a firm may lower its own price to reduce the potential fall in demand for its product.

Applications for governments

Governments use elasticities to understand how demand for goods and services might change during booms and recessions when setting policies. For example, if demand for certain public services increases during a recession due to falling incomes, the government would need to ensure sufficient provision.