Imagine you walk into a shop, searching for your favourite brand of chocolate, but you see its price has doubled. However, you notice that a similar type of chocolate is on sale. What would you do in this situation? Certain consumers might pick the cheaper but still similar chocolate. This is due to the price elasticity of demand (PED). Now, imagine that you got a new job that pays you twice the salary you were earning before. Would you still opt for the same chocolate, or would you consider buying a more expensive one? Certain consumers might opt to try out more expensive brands due to the income elasticity of demand (YED). To learn more about the impacts of PED and YED, read along!
PED Definition
PED stands for price elasticity of demand and can be defined as follows.
Price elasticity of demand (PED) measures how responsive demand is to a price change and is a valuable tool for making marketing decisions.
In other words, it measures how much demand for a good or service changes if the price of that product or service changes. We measure PED to answer the following question: if the price of a product changes, how much does demand increase, decrease, or stay the same?
Understanding PED is important for managers as it helps them understand how a price change will impact demand for their products. This is directly related to the revenue and profit the business makes. For example, if PED is elastic, and the company decides to decrease prices, demand will increase significantly more than the price decrease, potentially increasing company revenues.
PED is also useful for marketing managers regarding the marketing mix. PED directly impacts the 'price' element of the marketing mix. As a result, PED helps managers understand how to price current and new product developments.
YED Definition
YED stands for income elasticity of demand and can be defined as follows.
Income elasticity of demand (YED) measures how responsive demand is to a change in income and hence, is another useful tool for making marketing decisions.
Demand is not only affected by price (PED) but also by consumer income (YED). YED measures how much the demand for a product or service changes if there is a change in real income. We measure YED to answer the following question: if consumers' income changes, how much does demand for goods and services increase or decrease? Or does it stay the same?
Many products have a positive income elasticity of demand. As consumers' income increases, they demand more goods and services.
However, it is essential to note that this is not always the case. The demand for certain goods decreases when consumers make more money. We discuss these types of goods in more detail in the following sections.
Calculating PED and YED
Now that we understand the meaning of price and income elasticity of demand let's examine how to calculate PED and YED.
PED and YED: Calculating PED
Price elasticity of demand can also be defined as the percentage change in quantity demanded divided by the percentage change in price. To calculate the price of elasticity of demand, we use the following formula:
\(\hbox{PED}=\frac{\hbox{% Change in Quantity Demanded}}{\hbox{& Change in Price}}\)
At the beginning of the year Product A was selling at £2, and demand for Product A was 3,000 units. The following year Product A was selling at £5, and demand for Product A was 2,500 units. Calculate the price elasticity of demand.
\(\hbox{Change in quantity demanded}=\frac{2500-3000}{3000}\times100=-16.67\%\)
\(\hbox{Change in price}=\frac{5-2}{2}\times100=150\%\)
\(\hbox{PED}=\frac{-16.67\%}{150\%}=-0.11\)A PED of -0.11 implies inelastic demand.
Read along to find out more on how to interpret PED.
PED and YED: Calculating YED
Income elasticity of demand can also be defined as the percentage change in quantity demanded by the percentage change in real income. To calculate the income of elasticity of demand, we use the following formula:
\(\hbox{PED}=\frac{\hbox{% Change in Quantity Demanded}}{\hbox{& Change in Income}}\)
At the beginning of the year, consumers earned on average £18,000 and demanded 100,000 units of Product A. The following year consumers were earning on average £22,000, and demand was 150,000 units of Product A. Calculate the price elasticity of demand.
\(\hbox{Change in quantity demanded}=\frac{150,000-100,000}{100,000}\times100=50\%\)
\(\hbox{Change in Income}=\frac{22,000-18,000}{18,000}\times100=22.22\%\)
\(\hbox{YED}=\frac{50\%}{22.22\%}=2.25\)
A YED of 2.25 implies income elastic demand. Read along to find out more on how to interpret YED.
Difference between PED and YED
Besides the differences in definition and calculation, the interpretation of PED and YED also vary.
PED and YED: Interpreting PED
After calculating PED, we need to understand how to interpret its value. There are three different expected outcomes:
|PED| > 1: Demand is elastic if the absolute value of PED is greater than one. Elastic demand implies that a small price change will result in a significant shift in demand. Elastic demand is usually observed for substitutable goods.
For example, if the price of Coca-Cola increases by 25 pence, demand for it will probably decrease, as consumers will choose Pepsi or other soft drink alternatives instead.
Demand also tends to be elastic for luxury goods.
For instance, if aeroplane ticket prices and hotels increase by 30%, consumers will likely be more reluctant to book holidays.
|PED| <1: if the absolute value of PED is smaller than one, demand is inelastic. Inelastic demand implies that a small price change will result in an even smaller change in demand. In other words, even if the price changed significantly (significant increase or decrease), demand would not change much. Inelastic demand is common for goods that are necessities.
For example, if the price of essential food items like bread, milk, and rice increases by 15%, demand for them will likely not change much as consumers will always need basic food items.
|PED| = 1: if the absolute value of PED is equal to one, it means that demand is unitary.
Unitary elastic demand is where one unit of change in price results in the same unit change in demand.
This type of elasticity is relatively uncommon. Unitary elastic demand would imply that if a company sold 100 units of a product at £100 and increased its price to £101, demand would decrease to 99 units.
Figure 1 below summarises the relationship between the value of PED and the elasticity of demand.
FIg. 1 - Interpreting PED
PED and YED: Interpreting YED
Similarly to PED, we need to understand how to interpret the value of YED. There are three different expected outcomes:
0 <YED <1: If YED is larger than zero but smaller than 1, it implies that an increase in income will lead to an increase in quantity demanded. This tends to be the case for normal goods. Normal goods exhibit a positive relationship between income and demand. Normal goods include products like clothing, household appliances, or branded food items.
YED> 1: If YED is much higher than one, it implies income elastic demand. This means that a change in income will result in a proportionally larger change in quantity demanded. A YED larger than 1 tends to be the case for luxury goods - as average income increases, consumers tend to spend more on luxuries like designer clothes, expensive jewellery, or luxury holidays.
YED <0: If YED is smaller than zero, it implies a negative elasticity of demand. This means that an increase in income will result in a proportionally larger decrease in the quantity demanded. In other words, consumers demand less of this product when income increases. A YED smaller than zero tends to be the case for inferior goods.
Inferior goods are goods and services consumers demand less of when their income increases.
An example of inferior goods would be own-branded grocery items or budget food items.
To learn more about store brands, check out our explanation of Branding Strategy.
Figure 2 below summarises the relationship between the value of YED and the type of goods associated with it.
Fig. 2 - Interpreting YED
Importance of PED and YED
So, why is it important to understand PED and YED? Marketers always seek to understand consumer behaviour. They look for changes in consumer attitudes, perceptions, and buying behaviour. Therefore, the way consumers perceive and respond to prices will be of interest to marketers.
For instance, if a business is selling luxury products, it knows that the demand for its products is elastic. As a result, a company selling luxury holiday packages might decide to introduce price promotions during a time when the average consumer income is lower than in previous years.
Check out our explanation of Promotional pricing to explore this pricing strategy in more detail.
On the other hand, consider a supermarket that makes most of its revenue from selling lower-cost private label (store brand) products. Suppose the economy is experiencing healthy growth and consumers earn more money on average. In that case, the supermarket might consider introducing a new product line or brand with a selection of higher-end consumer goods.
Interpreting PED and YED - Key Takeaways
- PED stands fro price elasticity of demand and measures how responsive demand is to a change in price.
- PED can be measured by dividing the percentage change in quantity demanded by the percentage change in price.
- YED stands for income elasticity of demand and measures how responsive demand is to a change in income.
- YED can be measured by dividing the percentage change in quantity demanded by the percentage change in income.
- Luxury goods have an income elasticity of demand that is higher than 1.
- Inferior goods are goods that consumers purchase less of when their income increases.
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