3.3.2 - Elasticity and revenue decisions

Interpreting price elasticity

Price elasticity of demand measures the responsiveness of quantity demanded to a change in the product's own price.

An elasticity coefficient compares percentage changes, so it is a pure number rather than pounds or units. For ordinary demand relationships, price and quantity move in opposite directions and the supplied coefficient is negative. The magnitude, ignoring that negative sign for classification, shows responsiveness. An estimate of −2 means a 1% price increase is associated with approximately a 2% fall in quantity demanded, other relevant conditions unchanged.

The threshold is a magnitude of one. A coefficient of −0.4 is inelastic even though it is numerically greater than −1; “greater” and “smaller” can confuse the sign with responsiveness. Some sources state only the positive magnitude, so check the convention before interpreting direction.

Close substitutes encourage an elastic response: customers can switch when one supplier raises its price. Strong differentiation, loyalty or a necessary purchase with few alternatives can reduce responsiveness. A narrowly defined brand often faces more substitutes than the broad product category. Demand for a particular café's coffee can be elastic even if many customers continue buying coffee somewhere.

Time matters. An industrial customer may be unable to change an essential component immediately because alternative suppliers need approval, but can redesign its equipment over several years. The same price rise can therefore produce a smaller short-run response than a long-run response. Budget share and the ability to postpone a purchase also affect adjustment. These are reasons to investigate the actual market, rather than label every necessity inelastic or every luxury elastic.

Price changes and sales revenue

A price decision changes both the revenue received per sale and the number of sales, so both effects must be considered.

With elastic demand, a small price cut normally increases revenue because the proportionate sales gain outweighs the lower price. A small price rise normally reduces revenue. With inelastic demand, a small price rise normally increases revenue because the lost volume is relatively small; a cut normally reduces it. At unit elasticity, a small change has approximately no revenue effect. These rules assume other demand influences are unchanged and refer to the relevant price range.

A price cut with elastic demand

A theatre sells 1,000 tickets at £20. Supplied PED is −1.6; a 5% price cut is associated with an estimated 8% quantity rise.

1. Calculate the original revenue:

1. Apply each change to its own original value:

1. Multiply the two new values:

1. Revenue rises £520, or $520\div20{,}000\times100=2.6\%$. The coefficient was supplied, not calculated.

A price rise with inelastic demand

A replacement-parts supplier sells 1,000 units at £20. Supplied PED of −0.4 associates a 5% price rise with a 2% quantity fall.

1. Apply the price rise and quantity fall:

1. Calculate revenue:

1. Compare with £20,000 originally: revenue rises £580, or 2.9%. The relatively small volume loss is consistent with the inelastic estimate.

For IKEA's financial year ended 31 August 2025, its published review reported retail sales of €44.6 billion, compared with €45.1 billion in FY24, while volumes and visits increased following lower prices. The example separates revenue from quantity: selling more units at lower prices need not increase sales value. These aggregate figures alone cannot isolate a PED coefficient because the mix, locations and other demand influences also change. IKEA's FY25 review.

For finite changes, multiply the new price by the new quantity rather than simply subtract the percentage changes. A 10% price rise and a 10% quantity fall give $1.10\times0.90=0.99$, so revenue falls by 1%, not exactly zero. Supplied elasticity estimates often approximate local responses; do not extend them unchanged over very large changes or claim that a constant original-base percentage forecast is an exact unit-elastic demand curve.

Higher revenue does not guarantee higher profit. The theatre's extra ticket sales may require more staff or additional performances. If the extra cost exceeds £520, the forecast revenue gain would reduce profit. If there is spare capacity and little additional cost, the result is more attractive. A revenue objective and a profit objective can therefore suggest different prices.

Income responsiveness and demand

Income elasticity of demand describes the percentage quantity response to a change in consumers' income, other relevant conditions unchanged.

A positive supplied income elasticity identifies a normal good: rising income tends to increase demand. A value between zero and one, such as +0.3, indicates a proportionately smaller response. A value above one, such as +1.5, indicates a proportionately larger response and is commonly associated with income-sensitive luxury spending. A normal good need not be a luxury.

A negative value identifies an inferior good in the relevant market and income range: demand tends to fall as income rises, because consumers switch to alternatives they prefer. “Inferior” describes the income relationship, not a judgement that the product is defective. For example, demand for a basic coach service may fall as customers' incomes rise and they switch to a faster rail service. Its low price or the manager's opinion does not establish that relationship; evidence about income and demand is needed.

A normal service after incomes rise

A leisure service sells 4,000 visits at £12. Supplied income elasticity +1.5 associates a 4% income rise with a 6% volume rise.

1. Apply the estimated volume change:

1. Keep the unchanged price and calculate revenue:

1. Original revenue was £48,000, so the rise is £2,880 or 6%. This assumes the income change applies to the service's actual customers.

An inferior service after incomes rise

A basic coach service sells 2,000 journeys at £8. A supplied income elasticity of −0.5 associates a 6% income rise with a 3% quantity fall.

1. Reduce the original quantity:

1. At the unchanged price, calculate revenue:

1. Compare with $2{,}000\times£8=£16{,}000$: revenue falls £480 or 3%. Inferior describes this income relationship rather than the service's physical quality.

For a supplied elasticity of −0.5, a 4% income rise suggests a 2% fall in volume; a 4% income fall suggests a 2% rise, within the estimate's range. Businesses selling income-sensitive normal goods may face sharply reduced demand during a downturn, while demand for some inferior alternatives may increase. Neither outcome is automatic: preferences, employment patterns, competitor prices and the distribution of income also matter.

Income elasticity helps managers plan stock, capacity and target segments. A premium service may need contingency plans for weaker incomes; a retailer could maintain both basic and premium ranges to serve changing budgets. National income growth is not enough to forecast one firm's sales if the target customers' disposable incomes follow a different pattern.

The value and limits of elasticity estimates

Elasticity supports a decision when the estimate matches the product, customers, time period and change being considered.

PED helps evaluate price changes, discounts and the value of differentiation. A firm facing elastic demand may investigate loyalty, product quality or convenience that makes switching less attractive. Income elasticity helps forecast market opportunities and exposure to economic changes. Used together with cost and capacity information, these concepts can turn a vague expectation about customers into a clearer forecast.

Illustrative case: a regional parts manufacturer is considering a price rise. Its previous estimate suggests inelastic demand, but the estimate predates a rival entering the market. Customers now have a close alternative. Relying on the old coefficient could understate lost orders. A limited trial or customer research may provide more relevant evidence, though industrial contracts and customers' negotiating behaviour can make the response difficult to isolate.

Estimates are affected by data quality. A sales rise after a discount might partly reflect a simultaneous advertising campaign or seasonal demand. Aggregated data can hide elastic new customers and inelastic repeat customers. Coefficients may differ across countries, income groups and time horizons, and the effect of a price rise need not mirror a large price cut. Record the relevant assumptions instead of treating one number as a permanent law.

Managers must also consider purpose and stakeholders. A revenue-maximising price may be inconsistent with affordability, trust or a long-term positioning objective. A dynamic pricing system may identify customers' willingness to pay, but unexpected differences can provoke resentment. Forecasts should be compared with feasible supply and costs, then revised using actual outcomes. Elasticity is useful evidence within a decision, not a complete decision rule.