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Price Elasticity
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Price Elasticity of Demand
A clear guide to price elasticity of demand, covering how customers respond to price changes and how businesses use PED to make better pricing decisions.
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Created by an experienced Head of Business and examiner
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KEY POINTS
Price elasticity of demand measures how responsive demand is to a change in price.
PED is calculated by dividing the percentage change in quantity demanded by the percentage change in price.
If demand is price elastic, customers are highly responsive to price changes.
If demand is price inelastic, customers are less responsive to price changes.
A PED value greater than 1 means demand is price elastic.
A PED value less than 1 means demand is price inelastic.
Businesses use PED to judge whether a price rise or price cut is likely to increase revenue.
PED depends on factors such as substitutes, brand loyalty, necessity, price level and the proportion of income spent.
KEY DEFINITION
Price Elasticity of Demand
Price elasticity of demand measures how responsive the quantity demanded of a product is to a change in its price.
Main Explanation
Price elasticity of demand, often shortened to PED, measures how much demand changes when the price of a product changes. It helps businesses understand whether customers are likely to keep buying when prices rise, or whether they will quickly switch to alternatives.
The formula for PED is percentage change in quantity demanded divided by percentage change in price. The answer is often shown as a negative number because price and demand usually move in opposite directions. However, in Business Studies, students often focus on the size of the number when judging whether demand is elastic or inelastic.
Demand is price elastic when the PED value is greater than 1. This means customers are very responsive to a price change. If a business increases price when demand is elastic, quantity demanded may fall by a larger percentage than the price rise, causing revenue to fall. If the business cuts price, quantity demanded may rise by a larger percentage, increasing revenue.
Demand is price inelastic when the PED value is less than 1. This means customers are less responsive to a price change. If a business increases price when demand is inelastic, quantity demanded may fall by a smaller percentage than the price rise, so revenue may increase. This can make price rises attractive, but the business still needs to consider customer satisfaction and long-term loyalty.
Several factors affect PED. Demand is likely to be more elastic when there are many close substitutes, when customers can easily compare prices, or when the product is a large part of a customer’s income. Demand is likely to be more inelastic when the product is a necessity, has strong brand loyalty, has few substitutes or is needed urgently.
PED is useful for pricing decisions because it helps businesses predict the effect of changing price on revenue. For example, if demand is elastic, a price cut may increase total revenue. If demand is inelastic, a price rise may increase total revenue. However, PED does not tell the whole story because it focuses on revenue rather than profit.
A business must also consider costs, competitors, brand image and customer reaction. A price cut may increase revenue but reduce profit margins. A price rise may increase revenue in the short term but damage loyalty if customers feel the business is taking advantage of them. Strong exam answers therefore use PED to support pricing decisions, but also consider the wider business context.
✎ EXAMINER TIP
Students often confuse revenue and profit when using PED. A price cut may increase revenue if demand is elastic, but profit may still fall if the lower price reduces margins too much.
KEY FORMULAS(s)
Profit and Profitability Formulas
These key formulas help you calculate different profit measures and profitability ratios used in business.
Gross Profit
Gross profit = Revenue − Cost of sales
The profit made after deducting direct costs.
!
Remember: profit shows how much money has been made, while profitability shows how efficiently revenue is being turned into profit.
DATA TABLE
Income Statement for North Coast Coffee Ltd
This statement shows how revenue is converted into gross profit, operating profit and net profit.
Revenue
£250,000
Output
Fixed Costs
Variable Costs
Total Costs
Revenue
Profit / Loss
0 candles £1,200 £0 £1,200 £0 -£1,200
Net profit is the final profit remaining after all costs and expenses have been deducted from revenue.
PED and Revenue Decisions
This chart shows how pricing decisions affect revenue depending on whether demand is elastic or inelastic. It makes clear that price rises and price cuts have different revenue effects depending on customer responsiveness.
WORKED EXAMPLE
Worked Example: North Coast Coffee
How many coffees must be sold to break even?
Fixed Costs
£1,800
equity + long-term debt
Break-even output = Fixed costs ÷ Contribution per unit
Contribution per unit = Selling price − Variable cost
£3.50 − £1.10 = £2.40
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Step 1: Calculate contribution
£3.50 − £1.10 = £2.40
Contribution per unit is the amount each coffee contributes towards fixed costs.
BREAK-EVEN OUTPUT:
750 coffees per month
EXAM TIP
Always explain what the number means for the business. Do not just calculate the break-even point.
Elastic and Inelastic Demand
This diagram compares price elastic and price inelastic demand. It shows that elastic demand means customers respond strongly to price changes, while inelastic demand means customers are less responsive.
APPLICATION
Ryanair
Ryanair is a useful real-world example for understanding price elasticity of demand because customers often compare flight prices before booking. For some passengers, especially leisure travellers, demand may be price elastic because they can compare different airlines, airports, travel dates or even alternative ways to travel.
If Ryanair increases the price of a flight on a route with lots of competing options, some customers may switch to another airline or choose a different travel date. In this situation, the percentage fall in demand could be larger than the percentage rise in price, causing total revenue to fall.
However, demand may be more price inelastic at busy times, such as school holidays, weekends or popular events. Some passengers may still book even if prices are higher because they need to travel on a specific date or route. In this case, a price rise may increase revenue if the fall in demand is relatively small.
PED helps show why pricing decisions are not the same for every product or every customer. Ryanair needs to consider customer sensitivity, competition, route popularity and timing before changing prices. A lower price may fill more seats, but a higher price may increase revenue when demand is less responsive.
This independent educational case study is not affiliated with, endorsed by or sponsored by Greggs plc. Any financial figures used alongside this example should be treated as simplified or hypothetical estimates created for teaching purposes.
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ANALYSIS
EXAM FOCUS
Analysis questions require you to examine a business concept or issue in detail, breaking it down into its component parts. You should explain how and why something happens and consider its impact on the business.
How to Approach Analysis Questions
1
Identify the key issue or concept
2
Break it down
3
Explain how and why
4
Reach a reasoned conclusion
Read the question carefully and highlight the focus of the analysis.
Consider the different factors, causes or impacts related to the issue.
Provide clear explanations using business terms and links points to context.
Evaluate the overall implications for the business.
Example Analysis Question
North Coast Coffee is considering using break-even analysis before opening a second café.
Advantages
• Sales forecasts may be inaccurate.
• Assumes costs and revenue remain constant.
• External factors may reduce reliability.
• Ignores qualitative business factors.
Disadvantages
• Sales forecasts may be inaccurate.
• Assumes costs and revenue remain constant.
• External factors may reduce reliability.
• Ignores qualitative business factors.
Key Exam Tip
If you find it difficult to expand your answer and show the type of depth that an examiner is looking for in a top response, consider using the 'so what' approach.
Tesco carry out market research - so what? - this allows them to better understand customer needs - so what? as a result Tesco can provide goods more likely to sell - so what? - this will increase Tesco profit and ensure higher levels of customer satisfaction - so what? this means that customers are likely to become more loyal to Tesco.
Avoid These Exam Traps
Students often lose marks on calculation and analysis questions by making these mistakes. Watch out for them in your exam!
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Tip:
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2
Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
Tip:
Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
3
Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
Tip:
Helvetica Light is an easy-to-read font, with tall and narrow letters, that works well on almost every site.
Be precise. Read the question carefully. Show your working.
Small mistakes can cost big marks.
EXAM PRACTICE
Practice Question
Apply your knowledge of profit and profitability to answer this exam-style question.
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MINI CASE STUDY
North Coast Coffee Ltd is a premium coffee business which sells freshly roasted coffee beans through its online store and a small chain of independent cafés. The business has experienced strong sales growth due to increasing demand for high-quality speciality coffee products.
The business generates annual revenue of £250,000. Its cost of sales, including coffee beans, packaging and direct production costs, totals £100,000. North Coast Coffee Ltd also faces operating expenses of £80,000, including marketing, employee wages, rent and administration costs. In addition, the business pays £20,000 in interest and taxation each year.
The owner, Mia Thompson, is reviewing the company’s profitability because rising wage costs and increased competition in the premium coffee market have started to place pressure on operating profit margins. She is considering increasing prices slightly in order to protect profitability while still maintaining customer demand.
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EXAM QUESTION
Analyse the possible reasons for BrightBite’s falling profit margins and evaluate strategies it could use to improve profitability.
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HOW TO ANSWER
P
Point
E
Explain
A
Apply
C
Consequence
H
However...
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MODEL ANSWER
P
Point
Increasing prices could improve the profitability of North Coast Coffee Ltd because each sale would generate a larger amount of revenue and potentially increase profit margins.
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EXAMINER TIP
For full marks, make sure you analyse causes rather than just listing them, and evaluate realistic strategies with clear judgement. THINK: Which strategy would have the biggest impact and why?
CALCULATOR
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Price Elasticity of Demand
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