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Angela Emma Rudd BMA
Business Studies Elasticity
What Affects Demand?
What is it that makes firms sales go up and down? Will sales alter significantly if it changes
the price or if incomes change? Managers are interested in the strength of the relationship
between price and sales. If the price is cut by 10%, will sales go up by 5% or 50%?
Similarly, if average consumer income levels rise by 20%, what impact will this have on
demand for a firm's products?
The relationship between changes in demand and changes in price and income, is known as
the elasticity of demand. There are two types of elasticity of demand: price elasticity and
The Price elasticity of demand measures the sensitivity of demand to a change in price.
The Income elasticity of demand measures how sensitive demand is to change in income.
Why Does Elasticity Matter?
By calculating elasticity, a firm can identify how changes in price and income may affect
demand and, therefore, sales. This is important for planning. If, for example, a firm is
planning to cut prices, it will want to estimate the impact on demand and sales. This allows it
to ensure it has sufficient stock or capacity to meet demand. It may also have implications
for workforce planning. The business may need to hire extra people or get staff to work
overtime to meet orders. It will also want to calculate whether the price cut is worthwhile.
Will it lead to higher profits?
Similarly, if the economy is growing or shrinking, consumers incomes will be changing.
Businesses will want to estimate the possible effects on sales. Accurate forecasts ensure that
the firm can meet the likely demand.
In the case of price elastic demand, the value of the answer (ignoring the sign) will always be
bigger than 1 because the top line will be bigger than the bottom line of the equation. That is
the % change in demand will be larger than the % change in price that caused it. Thus
demand is sensitive to price changes and is described as price elastic. For example, if
demand rises by 20% when the price is cut by 10%, the price elasticity of demand will equal
+20/10 = 2 (notice we have ignored the negative sign.)
Price Inelastic Demand
The value will always be less than 1 (ignoring the sign again) when the good is price inelastic
because the top line of the equation will be less than the bottom line. In this case, the %
change in demand or sales will be smaller than the % price change that started the process.
This a price cut of 10%, leading to a change in demand of only 5%, will have a price
elasticity of demand of 0.5 or ½.
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Angela Emma Rudd BMA
What Determines the Value of the Price Elasticity?
The price elasticity of demand will be affected by a number of factors.
The availability of similar products.
If a consumer can switch easily from one product to another the demand is likely to
be quite sensitive to price changes hence demand will be price elastic. If one firm
increases its prices, consumers may switch to another product.…read more