Price and Income Elasticity of Demand

Definition of Elasticity

Elasticity measures the responsiveness of demand to a change in a relevant variable (e.g., price or income).

Price Elasticity of Demand (PED)

PED measures how demand for a product changes when its price changes. Formula: PED = % Change in Quantity Demanded / % Change in Price

Interpreting PED Results

PED > 1: Price elastic – Demand changes more than the price. PED < 1: Price inelastic – Demand changes less than the price. PED = 1: Unitary elastic – Demand changes exactly with the price.

Example of Elastic Demand

Price decreases from £1,000 to £900, increasing quantity demanded from 200 to 250 units. PED = 25% change in demand / 10% change in price = 2.5 (Price elastic)

Example of Inelastic Demand

Price increases from £100 to £125, decreasing quantity demanded from 500 to 400 units. PED = 20% change in demand / 25% change in price = -0.8 (Price inelastic)

Factors Influencing PED

1. Brand Strength: Strong brands are often price inelastic. 2. Necessity vs. Luxury: Necessities tend to be price inelastic. 3. Availability of Substitutes: More substitutes = more price elastic. 4. Time: Longer time periods make demand more elastic.

Income Elasticity of Demand (YED)

YED measures how demand changes when consumer income changes. Formula: YED = % Change in Quantity Demanded / % Change in Income

Interpreting YED Results

YED > 1: Luxury goods – Demand increases more than income. YED < 1 but > 0: Necessities – Demand increases with income, but less than the income rise. YED < 0: Inferior goods – Demand decreases as income increases.

Example of Luxury and Necessity Goods

Luxury Goods (e.g., branded goods, expensive holidays): YED > 1. Necessities (e.g., staple groceries, own-label products): YED < 1 but > 0

Combining PED and YED

Product A: Price inelastic, income inelastic (likely a necessity). Product B: Price elastic, income elastic (likely a luxury good).

Limitations of Elasticity Data

Hard to get reliable data on demand responses. Other factors, like consumer tastes, influence demand. Competitors' pricing decisions affect demand.

Key Terms

Price Elasticity of Demand (PED): Responsiveness of demand to price changes. Income Elasticity of Demand (YED): Responsiveness of demand to income changes.