Elasticity of Demand (AQA AS Business): Revision Note

Price elasticity of demand

• Price elasticity of demand (PED) measures how responsive demand for a product is to a change in price

  • In general,

    • when the price for a product increases, demand falls

    • when the price for a product decreases, demand rises

  • PED answers the question: By how much will demand change?

Calculation of PED

• PED will always be a negative value due to the inverse relationship between price and quantity

  • If the price goes up, the quantity demanded goes down

  • If the price goes down, the quantity demanded goes up

• PED can be calculated using the formula

$\text{PED = }\frac{\%\mathrm{Change}\mathrm{in}\mathrm{quantity}\mathrm{demanded}}{\%\mathrm{Change}\mathrm{in}\mathrm{price}}=\frac{\%△\mathrm{in}\hspace{0.17em}\mathrm{QD}}{\%△\mathrm{in}\mathrm{P}}$ 

• To calculate a % change, use the formula

 $\%\mathrm{Change}=\frac{\mathrm{New}\mathrm{value}-\mathrm{Old}\mathrm{value}}{\mathrm{Old}\mathrm{value}}\times 100$

Interpreting price elasticity of demand values

• The numerical value of PED indicates the responsiveness of demand to a change in price

Price elastic demand

• PED value lower than -1 (e.g -1.2)

• Demand is more responsive to a change in price

  • For every 1% change in price, demand will change by more than 1%

• An increase in price will lead to a fall in revenue; a decrease in price will lead to an increase in revenue

  • Examples include luxury products such as cars, smartwatches, foreign holidays, cinema visits, jewellery and branded goods

Price inelastic demand

• PED value is between 0 and -1 (e.g -0.7)

• Demand is less responsive to a change in price

  • For every 1% change in price, demand will change by less than 1%

• An increase in price will lead to an increase in revenue; a decrease in price will lead to an decrease in revenue

  • Examples include necessities such as bread, milk, eggs and potatoes; fuel; rent; toothpaste

    • Also addictive products such as cigarettes and sugary foods

Calculation of income elasticity of demand

• When household incomes change, spending on goods and services will either increase or decrease, depending on the type of good or service it is

  • Normal good: A good where demand rises when income increases, e.g. restaurant meals or new clothes

  • Inferior good: A good where demand falls when income increases, e.g. instant noodles or bus travel

  • Luxury good: A good where demand increases more than proportionally as income increases, e.g. designer handbags or sports cars

• Income elasticity of demand (YED) measures the responsiveness of demand for a product to a change in income levels

• Businesses are interested in how much the quantity demanded will change for different products

Calculation of YED

• The YED value can be positive or negative and the value is important in determining the type of good

  • A good with a positive YED value is considered to be a normal good

    • Normal goods can be classified as necessities or luxuries

  • A good with a negative YED value is considered to be an inferior good

• YED is calculated using the formula

$\text{YED = }\frac{\%\mathrm{Change}\mathrm{in}\mathrm{quantity}\mathrm{demanded}}{\%\mathrm{Change}\mathrm{in}\mathrm{income}}=\frac{\%△\mathrm{in}\hspace{0.17em}\mathrm{QD}}{\%△\mathrm{in}\mathrm{Y}}$

Interpreting income elasticity of demand values

Influences on YED

• YED is influenced by many factors in an economy that change the wages of workers

  • During a recession, wages usually fall and demand for inferior goods rises while demand for luxury goods falls

  • During a period of economic growth and rising wages, demand for luxury goods increases while demand for inferior goods decreases

  • Other influences on income include minimum wage legislation, taxation and increased international trade

• Understanding the income elasticity of demand is useful to businesses, as it can help them plan their production and products

  • Planning in this way will help them generate higher profits and be less exposed to economic downturns

Interpreting YED values

Normal good or service

• YED is more than 1 (positive)

• Demand rises when income rises, and demand falls when income falls

  • Demand is responsive to a change in income (income elastic)

• Examples include cars, smartwatches, foreign holidays, cinema visits, jewellery and branded goods

Necessity good or service

• YED is between 0 and 1 (positive)

• Demand is not very responsive to a change in income (income inelastic)

• Examples include staple food items, such as bread, milk, eggs and potatoes; fuel; and toothpaste

Inferior good or service

• YED is less than 0 (negative)

• Demand rises when income falls (negative income elasticity); demand falls when income rises

• Examples include public transport, domestic holidays, canned foods, unbranded/own label goods 

Using elasticity of demand to make marketing decisions

• Understanding PED and YED helps managers set prices, plan promotional activity and decide how much to make

Pricing and promotion

• If demand is price inelastic, a rise in price should lift revenue because customers stay

  • UK petrol shows very low elasticity: drivers cut trips only a little when prices climb 

• If demand is price elastic, businesses often cut prices or offer discounts to increase the volume of sales

  • Cinema popcorn with PED of around –0.8 loses buyers fast when price rises, so cinemas use bundle deals instead

• Example: When Cadbury shrank its Dairy Milk bars but kept the same price, sales hardly fell, showing demand for the bar is price inelastic, and the tactic protected profit 

Product and capacity planning

• Positive income elasticity signals a non-necessity or luxury item, where sales rise as incomes rise

  • Burberry enjoys strong growth when wages improve, so the firm expands its high‑end ranges and store space

• Negative income elasticity identifies inferior goods

  • Supermarket "value" noodles sold more during the 2022–23 cost‑of‑living squeeze, so factories increased night shifts to cope

  • Oatly’s premium oat milk drink saw fast UK sales growth as incomes recovered in 2024, so the brand invested in a new Peterborough packing facility

Marketing objectives

• Firms set objectives using elasticity estimates

  • B&Q identified that spending on DIY products is income elastic, so it continued to add products to its portfolio during the recent economic downturn

Inventory and production schedules

• Knowing that Pumpkin Spice Lattes have a high positive PED but a strong seasonal YED, Starbucks launches them every August and adjusts its coffee bean orders months ahead

Risk management

• Airlines such as Ryanair use dynamic pricing models built on PED estimates

  • If a flight is 80% full, prices rise sharply because late bookers are less price‑sensitive