Price, Income and Cross Elasticities of Demand
These Edexcel A-Level Economics revision notes cover unit 1.2.3, walking through how to calculate and interpret price elasticity of demand (PED), income elasticity of demand (YED), and cross elasticity of demand (XED) with worked examples and real-world applications throughout.
Price Elasticity of Demand (PED)
Definition: PED measures the responsiveness of quantity demanded to a change in the good's own price.
| PED Value | Classification | Explanation & Example |
|---|---|---|
| \[ \text{PED} = 0 \] | Perfectly inelastic | Quantity demanded does not respond to price changes (theoretical, e.g., essential medicine). |
| \[ 0 < \text{PED} < 1 \] | Relatively inelastic | Quantity demanded changes by a smaller percentage than the price change (e.g., necessities, addictive goods). |
| \[ \text{PED} = 1 \] | Unitary elasticity | Quantity demanded changes by the exact same percentage as the price. |
| \[ \text{PED} > 1 \] | Relatively elastic | Quantity demanded changes by a larger percentage than the price change (e.g., luxuries, goods with many substitutes). |
| \[ \text{PED} = \infty \] | Perfectly elastic | Any price increase causes quantity demanded to fall to zero (theoretical). |
Key Determinants of PED:
- Number & Closeness of Substitutes: More/better substitutes mean higher (more elastic) PED as consumers can easily switch if price rises.
- Necessity vs. Luxury: Necessities tend to be price inelastic as consumers must purchase them regardless of price; luxuries tend to be elastic as consumers can forego them if prices rise.
- Addictiveness: Addictive goods (e.g., cigarettes) often have inelastic demand because consumers find it hard to reduce consumption even if prices rise.
- Proportion of Income: Goods that take a large portion of income tend to be more price elastic as price changes significantly affect consumers' budgets.
- Time Period: In the short run, demand is often more inelastic as consumers are slow to respond to price changes. In the long run, demand can become more elastic as consumers find alternatives or adjust their habits.
Income Elasticity of Demand (YED)
Definition: YED measures the responsiveness of quantity demanded to a change in consumer income.
| YED Value | Classification | Explanation & Example |
|---|---|---|
| \[ \text{YED} > 1 \] | Normal Luxury Good (Income Elastic) | Demand increases more than proportionally following a rise in income. (e.g., holidays, designer goods). |
| \[ 0 < \text{YED} < 1 \] | Normal Necessity (Income Inelastic) | Demand increases but less than proportionally following a rise in income (e.g., food, basic clothing). |
| \[ \text{YED} < 0 \] | Inferior Good | Demand decreases as income rises (e.g., budget brands, bus travel). |
Cross Elasticity of Demand (XED)
Definition: XED measures the responsiveness of quantity demanded for Good A to a change in the price of Good B.
| XED Value | Relationship | Explanation & Example |
|---|---|---|
| \[ \text{XED} > 0 \] | Substitutes | A rise in the price of Good B increases demand for Good A (e.g., Coke and Pepsi). A higher positive value indicates stronger substitutability. |
| \[ \text{XED} < 0 \] | Complements | A rise in the price of Good B decreases demand for Good A (e.g., printers and ink). A lower negative value (e.g., -2.5) indicates stronger complementarity. |
| \[ \text{XED} = 0 \] | Unrelated goods | No relationship between the two products. |
Significance of Elasticities
For Firms:
PED & Revenue: To maximise revenue, a firm should raise price if demand is inelastic (PED < 1) and lower price if demand is elastic (PED > 1).
YED: Helps plan for the economic cycle. Produce/sell more luxuries in booms and more inferior goods in recessions.
XED: Informs pricing and competitive strategy. Understanding complements and substitutes is vital.
For Governments:
PED & Taxation: Placing an indirect tax on goods with inelastic demand (e.g., cigarettes) raises significant tax revenue with a relatively small fall in quantity. Taxing elastic goods can severely reduce sales and employment.
PED & Subsidies: Subsidising goods with elastic demand (e.g., green tech) can cause a large increase in consumption.
Exam Preparation
-
Calculations: Be confident calculating %
changes and each elasticity. Show your working.
\[ \%\Delta = \frac{\text{New} - \text{Old}}{(\text{New} + \text{Old})/2} \times 100 \]
- Interpretation: The sign (positive/negative) of YED and XED is as important as the number. For PED, the number's size is key.
- Application: Always link the numerical result to its real-world meaning (e.g., PED = -0.4 means demand is inelastic, so a tax will be largely passed to the consumer").
- Evaluation: Elasticity is not static—it can change over time or if the price change is very large.