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Price elasticity of demand
The price elasticity of demand (PED) measures the responsiveness of demand to change in price.
To calculate the value of the PED, you can use the formula below:
For example, suppose the price rises by 10% and the quantity demanded falls by 5%. Then the PED would be:
/frac{-5}{10}=-0.5
Values of the price elasticity of demand
The price elasticity of demand can take on different numerical values. Numerical values can correspond to particular terms, such as “perfectly inelastic” corresponding to a PED value of zero.
Here is a table with a list of key PED values and corresponding terms:
| Type of PED | PED value | Meaning |
| Perfectly inelastic | 0 | Demand completely unresponsive to price change. Vertical demand curve. |
| Inelastic | Between 0 and -1 | Demand not very responsive to price change. Steep demand curve. |
| Unit | -1 | Demand responds to price in equal percentages. |
| Elastic | Below -1 | Demand very responsive to price change. |
| Perfectly elastic | Negative infinity | Demand extremely responsive to price change. Horizontal demand curve. |
Graphs with different price elasticities of demand
If demand is price-inelastic, the demand curve is likely to be steep.
Conversely, if demand is price-elastic, the demand curve is likely to be flatter.
The diagram below shows the demand curves for different PED values.
Note that unitary PED = -1, the demand curve is as shown below. This is the shape required so that when the price falls by a given percentage, the quantity demanded rises by the same percentage.
What determines the price elasticity of demand?
To remember the determinants of the PED, you can use the SNAPS acronym:
- (Number of) substitutes. More substitutes makes switching easier, so PED more elastic.
- This could change over time as more substitutes are discovered (or contrarily if firms differentiate their products from one another over time).
- Necessity or luxury. If a good is a necessity, its PED is more inelastic.
- The same good may be necessities or luxuries to different people or countries.
- For example, a rural community may depend very heavily on cars as a necessity to get around, leading to an inelastic PED. However in cities where there are public transport connections, the car may not be as much of a necessity. This relates to the point about number of substitutes.
- Addictiveness makes the PED more inelastic. Examples include cigarettes and alcohol.
- Percentage of income spent on good. A lower % of income spent on the good means a price change has less effect on remaining income, so PED more inelastic.
- Short run vs long run. In the long run, contracts end and more substitutes are discovered. So consumers can respond more – PED more elastic.
Why does PED matter?
The PED affects how businesses price their products. It affects the change in revenue from changing price:
- Revenue = price x quantity.
- If PED is inelastic: a given percentage rise in the price leads to a smaller (magnitude) percentage fall in quantity. So overall, revenue rises.
- If PED is elastic: a given % rise in the price leads to a larger (magnitude) percentage fall in quantity. So overall, revenue falls.
In addition, the PED influences the consequences of indirect taxes and subsidies:
- If demand is price-inelastic, a tax causes less of a fall in quantity and a much greater increase in price [compared to PED elastic].
- Greater tax revenue; but most of the tax is passed on to consumer.
- With subsidy, an inelastic PED means price falls further, benefitting consumers more than producers.
Income elasticity of demand
The income elasticity of demand (YED) measures the responsiveness of demand to change in income.
YED can be calculated using the following formula:
\(YED = \frac{% change in demand}{% change in income}\)
For example, suppose incomes rise by 10%. As a result, demand for flight tickets rises by 15%. Then the YED is 15% divided by 10%, giving YED = 1.5.
Goods are defined as “inferior” when their income elasticity of demand is negative. This means that as incomes rise, demand falls (and vice versa).
- Inferior goods include used goods, such as second-hand cars, and value ranges, such as Tesco value products.
- Suppose incomes fall due to an economic downturn. Consumers’ purchasing power falls as a result. so consumers may buy fewer new or luxury items and instead buy more second-hand or value products.
- Conversely, suppose incomes rise due to economic growth. This increases consumers’ purchasing power. Hence consumers may demand more luxuries and fewer used goods.
Goods with an income elasticity of demand above zero are referred to as normal goods. These are split into two subgroups:
- Goods with YED between 0 and 1 are referred to as “normal inelastic” goods.
- For these goods, demand increases but at a slower rate than income increases.
- Typical examples include certain necessities such as basic foods and utilities (energy, water).
- Goods with an income elasticity of demand above 1 are “normal elastic” goods. These can also be termed luxury goods.
- These are goods whose demand is very response to small changes in income.
- These tend to be luxuries such as expensive holidays.
- Often when income falls, these luxuries may be the first item that consumers cut back on.
- When income rises, demand rises at an even faster rate. This means as the economy grows, these goods are likely to form an even larger proportion of the total value of goods and services.
How is the income elasticity of demand used?
- Firms can use YED to forecast future demand for their product.
- Governments and firms can also predict which sectors will grow and contract as an economy gets richer or as a downturn occurs. If there is economic growth that increases incomes, demand for normal goods will rise. However demand for inferior goods will fall.
The income elasticity of demand is determined by:
- Whether the good is a luxury or a necessity. Luxuries are likely to have a YED above 1. Necessities often have a YED between 0 and 1.
- The income level of the consumer or consumers. As consumers get richer, they may consume more necessities such as energy. However at some point with income increasing, consumers’ energy needs may already be satisfied. In this case, the YED may fall as income increases.
Cross price elasticity of demand
The cross price elasticity of demand (XED) measures the responsiveness of demand for good A to change in price of another good B.
To calculate the XED, use the formula:
\(XED = \frac{% change in demand for good A}{% change in price of good B}\)
For example, suppose the price of electric cars falls by 10%. This leads to a fall in demand for petrol cars by 2%. The XED is -2% divided by -10%, giving a value of 0.2.
If the XED > 0, the two goods are substitutes.
- For example, electric cars and petrol cars may be considered substitutes.
- A fall in price of electric cars leads consumers to switch from petrol cars to electric cars. This lowers demand for petrol cars.
However if the XED < 0, the two goods are complements.
- For example, phones and phone charges are complements.
- A rise in price of phones reduces phone demand. Because there are fewer phones needing to be charged, this reduces the demand for phone chargers.
Why is the cross price elasticity of demand useful?
- A firm can use the XED to forecast the effects on demand from a change in price by a substitute or complement good.
- The government can estimate the effect of taxes and subsidies for one good on demand for related goods.
- For example, suppose the government taxes petrol cars, raising the price of petrol cars. To what extent will the demand for electric vehicles rise? This depends on the XED.
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