The concept of elasticity of demand
→ Elasticity of demand measures how responsive the quantity demanded of a product is to a change in a factor affecting demand.
→ It helps a business understand how strongly customers may respond to changes in price, income or promotion.
→ The three forms required are:
→ Price elasticity of demand (PED) → responsiveness of quantity demanded to a change in price.
→ Income elasticity of demand (YED) → responsiveness of quantity demanded to a change in consumer income.
→ Promotional elasticity of demand (PED/Promotional elasticity) → responsiveness of quantity demanded to a change in promotional expenditure.
Price elasticity of demand (PED)
→ PED measures the responsiveness of quantity demanded to a change in the price of a product.
Formula
→ PED = % change in quantity demanded ÷ % change in price
→ Because price and quantity demanded normally move in opposite directions, PED is usually negative.
→ In business decision-making, the absolute value is often used when interpreting the strength of the response.
Example
→ Price increases by 10%.
→ Quantity demanded falls by 20%.
→ PED = −20% ÷ 10% = −2
→ Absolute value = 2
→ Demand is therefore price elastic.
Interpreting PED
| PED value | Type of demand | Meaning |
|---|---|---|
| Greater than 1 in absolute value | Elastic | Quantity demanded changes by a greater percentage than price |
| Less than 1 in absolute value | Inelastic | Quantity demanded changes by a smaller percentage than price |
| Equal to 1 in absolute value | Unit elastic | Quantity demanded changes by the same percentage as price |
| 0 | Perfectly inelastic | Quantity demanded does not change |
| Infinite | Perfectly elastic | Very small price change causes a very large change in quantity demanded |
Elastic demand
→ % change in quantity demanded > % change in price
→ Customers are highly responsive to price changes.
→ A price increase → relatively large fall in quantity demanded.
→ A price decrease → relatively large increase in quantity demanded.
Example:
→ If price rises by 10% and quantity demanded falls by 30%, PED = −3.
→ Demand is elastic.
Inelastic demand
→ % change in quantity demanded < % change in price
→ Customers are less responsive to price changes.
→ A price increase → relatively small fall in quantity demanded.
→ A price decrease → relatively small increase in quantity demanded.
Examples may include:
→ essential medicines
→ basic food products
→ products with few substitutes
PED and total revenue
→ Total revenue = Price × Quantity sold
→ PED is particularly useful when a business is considering a price change.
When demand is elastic
→ Price increase → quantity demanded falls proportionately more → total revenue usually falls.
→ Price decrease → quantity demanded rises proportionately more → total revenue usually rises.
When demand is inelastic
→ Price increase → quantity demanded falls proportionately less → total revenue usually rises.
→ Price decrease → quantity demanded rises proportionately less → total revenue usually falls.
When demand is unit elastic
→ Percentage change in price = percentage change in quantity demanded.
→ A price change generally leaves total revenue approximately unchanged.
Important:
→ PED shows the expected relationship between price and quantity demanded, but actual revenue can also be affected by other factors.
Income elasticity of demand (YED)
→ YED measures the responsiveness of quantity demanded to a change in consumer income.
Formula
→ YED = % change in quantity demanded ÷ % change in income
→ Unlike PED, YED can be positive or negative.
Example
→ Consumer income increases by 10%.
→ Quantity demanded increases by 20%.
→ YED = 20% ÷ 10% = +2
→ Demand is income elastic.
Interpreting YED
| YED | Type of good | Meaning |
|---|---|---|
| Positive | Normal good | Demand rises as income rises |
| Positive and greater than 1 | Income elastic normal good | Demand rises proportionately more than income |
| Positive but less than 1 | Income inelastic normal good | Demand rises proportionately less than income |
| Negative | Inferior good | Demand falls as income rises |
Normal goods
→ YED > 0
→ Higher income → higher demand.
Examples:
→ restaurant meals
→ holidays
→ new cars
→ higher-quality clothing
Income elastic goods
→ YED > 1.
→ Demand changes proportionately more than income.
→ Often associated with products consumers buy more of when their incomes rise significantly.
Income inelastic goods
→ 0 < YED < 1.
→ Demand rises, but by a smaller percentage than income.
→ These may include basic necessities.
Inferior goods
→ YED < 0
→ Higher income → lower demand.
Example:
→ A consumer may switch from a low-cost generic product to a more expensive branded product when their income increases.
Promotional elasticity of demand
→ Promotional elasticity of demand measures the responsiveness of quantity demanded to a change in promotional expenditure.
Formula
→ Promotional elasticity of demand = % change in quantity demanded ÷ % change in promotional expenditure
Example
→ Promotional expenditure increases by 20%.
→ Quantity demanded increases by 30%.
→ Promotional elasticity = 30% ÷ 20% = 1.5
→ Demand is responsive to promotional expenditure.
Interpreting promotional elasticity
→ Greater than 1 → quantity demanded changes proportionately more than promotional expenditure.
→ Less than 1 → quantity demanded changes proportionately less than promotional expenditure.
→ Equal to 1 → quantity demanded changes by the same percentage as promotional expenditure.
→ A higher promotional elasticity suggests that additional promotional spending may have a relatively strong effect on demand.
Impact of elasticity on business decisions
Pricing decisions
→ PED helps businesses decide whether changing price is likely to increase or decrease total revenue.
→ Elastic demand → businesses may be cautious about raising prices.
→ Inelastic demand → a business may have greater scope to raise prices without losing a proportionately large amount of sales.
Revenue forecasting
→ Elasticity helps businesses estimate how changes in price, income or promotion may affect sales revenue.
→ Elasticity estimate → expected change in quantity demanded → expected sales → revenue forecast.
Marketing decisions
→ Promotional elasticity helps businesses assess the likely response to advertising and promotional spending.
→ High promotional elasticity → additional promotion may generate a relatively large increase in demand.
→ Low promotional elasticity → increasing promotional expenditure may have a relatively small effect on demand.
Product planning
→ YED helps businesses predict how demand may change when consumer incomes change.
→ High positive YED → rising incomes may create significant opportunities for the product.
→ Negative YED → rising incomes may reduce demand.
Production decisions
→ Elasticity estimates can help businesses forecast future sales.
→ Expected demand change → production planning → resource requirements → inventory decisions.
Market expansion
→ YED can help businesses decide which products or markets are likely to benefit from rising or falling incomes.
→ For example, a business selling luxury products may focus on markets where incomes are increasing.
Limitations of elasticity
Elasticity estimates may be inaccurate
→ Elasticity is usually calculated using historical data.
→ Past consumer behaviour may not accurately predict future behaviour.
→ A business may therefore make an incorrect decision based on the calculated value.
Other factors may change at the same time
→ PED assumes other factors affecting demand remain unchanged.
→ In reality, competitors’ prices, advertising, consumer preferences and economic conditions may change simultaneously.
→ This makes it difficult to identify the exact effect of price.
Elasticity can change over time
→ Consumer behaviour is not fixed.
→ New substitutes, changes in income, changing preferences or technological developments can alter elasticity.
→ A PED calculated today may not remain appropriate in the future.
Different consumers may respond differently
→ An average elasticity figure may hide differences between customer groups.
→ Some customers may be highly price sensitive while others may be relatively insensitive.
Product definition matters
→ Elasticity can differ depending on how broadly the product is defined.
→ Demand for soft drinks as a whole may be less elastic than demand for one particular brand because individual brands have more substitutes.
External factors can affect results
→ Economic conditions, government policies, seasonal changes and unexpected events can affect demand.
→ A change in quantity demanded may therefore not be caused only by the factor being studied.
PED does not directly measure profit
→ PED helps analyse demand and revenue, but it does not consider costs.
→ A price change that increases revenue may still reduce profit if costs are high.
→ Revenue ≠ profit
Promotional elasticity has limitations
→ An increase in sales following promotion may also be caused by seasonality, changes in price, competitors’ actions or changing consumer preferences.
→ It may therefore be difficult to measure the exact effect of promotional expenditure.
YED has limitations
→ Consumer income may not be the only reason demand changes.
→ Changes in tastes, prices, substitutes and consumer confidence may also affect demand.
→ Therefore, YED should be used alongside other market information.
Using elasticity in business decisions
→ Calculate elasticity → interpret the result → consider other factors → assess revenue/cost implications → make the decision → monitor actual results
→ Elasticity is therefore a useful decision-making tool, but it should not be used in isolation. A business should combine elasticity data with information about competitors, customers, costs, market conditions and business objectives.