Elasticity

What you'll learn

Elasticity measures how responsive demand or supply is to changes in price or income. Understanding elasticity helps businesses make pricing decisions and governments predict the impact of taxes. This topic is essential for both paper 1 and paper 2 of your WJEC GCSE Economics exam, appearing in multiple-choice, short-answer, and data-response questions.

Key terms and definitions

Price elasticity of demand (PED) — a measure of how much the quantity demanded of a product changes when its price changes, calculated as percentage change in quantity demanded ÷ percentage change in price

Elastic demand — when the percentage change in quantity demanded is greater than the percentage change in price (PED > 1), meaning demand is responsive to price changes

Inelastic demand — when the percentage change in quantity demanded is smaller than the percentage change in price (PED < 1), meaning demand is unresponsive to price changes

Income elasticity of demand (YED) — a measure of how much the quantity demanded changes when consumer income changes, calculated as percentage change in quantity demanded ÷ percentage change in income

Normal goods — products with positive income elasticity, where demand increases as income rises (examples: restaurant meals, new clothing)

Inferior goods — products with negative income elasticity, where demand falls as income rises (examples: budget supermarket own-brands, second-hand clothing)

Total revenue — the total income a business receives from selling its products, calculated as price × quantity sold

Unitary elastic demand — when the percentage change in quantity demanded equals the percentage change in price (PED = 1)

Core concepts

Understanding price elasticity of demand

Price elasticity of demand measures consumer responsiveness to price changes. The formula is:

PED = % change in quantity demanded ÷ % change in price

PED values are always negative because price and quantity demanded move in opposite directions (the law of demand). However, we often ignore the minus sign and focus on the absolute value.

Interpreting PED values:

• PED > 1: Elastic demand (responsive to price changes)
• PED < 1: Inelastic demand (unresponsive to price changes)
• PED = 1: Unitary elastic demand
• PED = 0: Perfectly inelastic (quantity demanded doesn't change at all)
• PED = infinity: Perfectly elastic (any price increase causes demand to fall to zero)

Factors affecting PED:

• Availability of substitutes — products with many alternatives (like different brands of cola) have elastic demand because consumers can easily switch
• Necessity vs luxury — necessities like bread and milk tend to have inelastic demand; luxuries have elastic demand
• Proportion of income — expensive items like cars have elastic demand; cheap items like salt have inelastic demand
• Time period — demand becomes more elastic over time as consumers find alternatives
• Addiction or habit — products like cigarettes have inelastic demand despite being expensive

Price elasticity and total revenue

Understanding PED is crucial for businesses making pricing decisions because it affects total revenue.

When demand is elastic (PED > 1):

• Price increase → quantity falls by a larger percentage → total revenue falls
• Price decrease → quantity rises by a larger percentage → total revenue rises
• Strategy: Lower prices to increase revenue

When demand is inelastic (PED < 1):

• Price increase → quantity falls by a smaller percentage → total revenue rises
• Price decrease → quantity rises by a smaller percentage → total revenue falls
• Strategy: Raise prices to increase revenue

When demand is unitary elastic (PED = 1):

• Price changes don't affect total revenue
• The percentage change in price is exactly offset by the percentage change in quantity

Real-world example: Budget airlines like Ryanair recognize that demand for flights is relatively elastic. They keep base prices low to maximize passenger numbers and total revenue, then charge for extras (baggage, seat selection) where demand is more inelastic.

Calculating PED step-by-step

To calculate PED accurately, follow these steps:

Step 1: Calculate the percentage change in quantity demanded

• Formula: (New quantity - Original quantity) ÷ Original quantity × 100

Step 2: Calculate the percentage change in price

• Formula: (New price - Original price) ÷ Original price × 100

Step 3: Apply the PED formula

• PED = % change in quantity demanded ÷ % change in price

Step 4: Interpret the result

• Is demand elastic, inelastic, or unitary elastic?

Income elasticity of demand

Income elasticity of demand (YED) measures how demand responds to changes in consumer income. The formula is:

YED = % change in quantity demanded ÷ % change in income

Unlike PED, YED can be positive or negative, which tells us about the type of good.

Interpreting YED values:

Positive YED (normal goods):

• YED between 0 and +1: Normal necessity (demand rises with income, but proportionately less) — examples: basic foods, utilities
• YED > +1: Luxury/superior good (demand rises with income, proportionately more) — examples: holidays abroad, designer clothing, restaurant meals

Negative YED (inferior goods):

• YED < 0: Demand falls as income rises — examples: supermarket value ranges, bus travel (replaced by car travel), discount retailers

Business applications:

During economic growth (rising incomes), businesses selling luxury goods with high positive YED will see strong demand increases. During recession, these same businesses suffer significant falls in demand. Companies selling inferior goods may actually benefit during recessions.

UK example: During the 2008-09 recession, discount retailers like Poundland expanded rapidly as consumers switched from more expensive alternatives. When incomes recovered, some consumers switched back to higher-priced brands.

Factors affecting income elasticity

Several factors determine whether a product is normal or inferior:

Consumer perceptions:

• Products perceived as low quality tend to be inferior goods
• Products associated with status or luxury have high positive YED

Income levels:

• The same product can be normal for some consumers and inferior for others
• Own-brand products might be normal goods for low-income households but inferior for high-income households

Economic development:

• As countries develop, some normal goods become necessities (YED falls)
• New luxury goods emerge with high positive YED

Price elasticity of supply

While WJEC GCSE focuses primarily on demand elasticity, you should understand that price elasticity of supply (PES) measures how responsive quantity supplied is to price changes.

PES = % change in quantity supplied ÷ % change in price

Factors affecting PES:

• Time period (supply becomes more elastic over time)
• Availability of spare capacity
• Ability to store stocks
• Ease of switching production

Supply is typically more elastic in the long run because producers can build new factories, hire workers, and increase capacity.

Worked examples

Example 1: Calculating and interpreting PED

Question: A coffee shop reduces the price of cappuccinos from £3.00 to £2.70. Weekly sales increase from 400 to 480 cups. Calculate the price elasticity of demand and explain what the result means for the coffee shop's revenue. (6 marks)

Answer:

Step 1: Calculate percentage change in quantity demanded

• Change in quantity = 480 - 400 = 80
• % change = (80 ÷ 400) × 100 = 20%

Step 2: Calculate percentage change in price

• Change in price = £2.70 - £3.00 = -£0.30
• % change = (-0.30 ÷ 3.00) × 100 = -10%

Step 3: Calculate PED

• PED = 20% ÷ -10% = -2 (or 2 ignoring the sign)

Step 4: Interpretation

• PED of 2 means demand is elastic (2 > 1). A 1% decrease in price leads to a 2% increase in quantity demanded.
• Original revenue = £3.00 × 400 = £1,200
• New revenue = £2.70 × 480 = £1,296
• Revenue has increased by £96 per week. Because demand is elastic, the price reduction has successfully increased total revenue.

Mark scheme guidance: 1 mark for each correct calculation, 1 mark for correct PED value, 1 mark for identifying elastic demand, 2 marks for explaining the revenue impact with supporting figures.

Example 2: Income elasticity and business planning

Question: A luxury car manufacturer finds that when average household income rises by 5%, demand for its cars increases by 12%. Calculate the income elasticity of demand and explain how this information might influence the company's business strategy during an economic recession. (5 marks)

Answer:

Calculation:

• YED = % change in quantity demanded ÷ % change in income
• YED = 12% ÷ 5% = +2.4

Interpretation:

• YED of +2.4 means this is a luxury good (YED > 1). Demand is highly responsive to income changes and rises proportionately more than income.

Business implications during recession:

• During a recession, household incomes fall, so demand for luxury cars would fall by a larger percentage
• With YED of 2.4, a 5% fall in income would cause a 12% fall in demand
• The company should prepare for significant sales reductions: cutting production, reducing workforce, or diversifying into less luxurious models
• They might focus marketing on wealthy consumers less affected by recession

Mark scheme guidance: 2 marks for correct YED calculation and identification as luxury good, 3 marks for explaining recession impact with application to the business context.

Example 3: PED and indirect taxes

Question: The government increases tax on cigarettes, raising the price from £10.00 to £11.50 per packet. Sales fall from 200 million to 190 million packets per year. Calculate PED and explain why the government can raise significant tax revenue despite the price increase. (5 marks)

Answer:

Calculation:

• % change in quantity = [(190 - 200) ÷ 200] × 100 = -5%
• % change in price = [(11.50 - 10.00) ÷ 10.00] × 100 = 15%
• PED = -5% ÷ 15% = -0.33 (or 0.33)

Analysis:

• PED of 0.33 means demand is inelastic (0.33 < 1)
• Cigarettes are addictive, have few substitutes, and are a habit purchase, making demand unresponsive to price
• When demand is inelastic, price increases lead to higher total revenue
• Original revenue = £10 × 200m = £2,000m
• New revenue = £11.50 × 190m = £2,185m
• Revenue increases by £185m despite lower sales volume because the price rise more than compensates for the quantity fall
• The government benefits from inelastic demand for "sin taxes"

Mark scheme guidance: 2 marks for correct calculation, 3 marks for explaining inelastic demand and its effect on tax revenue with numerical support.

Common mistakes and how to avoid them

• Confusing elastic with inelastic — Remember: elastic = responsive (big reaction to price changes), inelastic = unresponsive (small reaction). Think "elastic band" = stretchy and responsive.

• Getting the formula backwards — PED is always % change in quantity demanded ÷ % change in price, never the other way around. Write the formula at the start of calculations.

• Forgetting to convert to percentages — You must calculate percentage changes, not just absolute changes. A price change from £2 to £3 is not 1, it's 50%.

• Misinterpreting total revenue effects — When demand is elastic, price and revenue move in opposite directions (price up = revenue down). When inelastic, they move together (price up = revenue up). Draw a simple diagram to check.

• Confusing normal and inferior goods — Normal goods have positive YED (demand rises with income), inferior goods have negative YED (demand falls with income). Don't confuse "normal" with "necessity."

• Not reading the question carefully — Questions may ask for PED or YED, about price changes or income changes. Underline the key instruction before starting your calculation.

Exam technique for "Elasticity"

• "Calculate" questions — Show all working clearly: percentage change calculations, then the elasticity formula, then your answer. You can earn method marks even if your final answer is wrong.

• "Explain" command words — Don't just calculate; interpret your answer. State whether demand is elastic/inelastic, what this means for responsiveness, and the implications for revenue or business decisions.

• Application marks — WJEC rewards application to the context. If the question is about a specific business or product, refer to it explicitly. Don't give generic answers about "a business" when the question is about "this coffee shop."

• Data response questions — Extract figures accurately from tables or graphs before calculating. Check units (thousands? millions?) and round appropriately. A PED of 2.437 can be given as 2.4 or "approximately 2.4."

Quick revision summary

Elasticity measures responsiveness of demand to price or income changes. PED > 1 is elastic (responsive); PED < 1 is inelastic (unresponsive). Elastic demand: lower prices increase revenue. Inelastic demand: higher prices increase revenue. YED shows income responsiveness: positive for normal goods, negative for inferior goods. Key factors affecting PED: substitutes, necessity, proportion of income, time. Calculate elasticity by dividing percentage change in quantity by percentage change in price/income. Always interpret your calculation and apply it to the business context for full marks.