✨ Welcome to Price Elasticity of Demand (PED)! ✨

Hello future economists! This chapter is one of the most practical and important concepts you will learn in the "Allocation of Resources" section. We’ve already looked at how price determines the quantity demanded (the Law of Demand). But how much does it determine it?

That's where Price Elasticity of Demand comes in! It tells businesses and governments just how much consumers freak out (or don't freak out) when the price changes. Mastering PED is crucial because it explains real-world decisions about pricing, taxation, and revenue. Let’s dive in!

1. Defining Price Elasticity of Demand (PED) (Syllabus 2.7.1)

What is Elasticity?

Think of elasticity in Economics just like a rubber band. If you pull it (change the price), how much does it stretch (change the quantity demanded)?

PED measures the responsiveness of the quantity demanded for a good or service when its price changes.

  • If a small price change leads to a huge change in quantity demanded, demand is sensitive (or elastic).
  • If a huge price change leads to only a small change in quantity demanded, demand is insensitive (or inelastic).

Key Term:
Price Elasticity of Demand (PED): The measure of the responsiveness of quantity demanded to a change in the price of the product.

Quick Review

PED answers this key question: If a business puts up its price by 10%, will they lose 5% of their customers or 50% of their customers?

2. Calculating and Interpreting PED (Syllabus 2.7.2)

The PED Formula

We calculate PED using a ratio of percentage changes:

\[ \text{PED} = \frac{\%\,\text{Change in Quantity Demanded}}{\%\,\text{Change in Price}} \]

Don't worry if this seems tricky at first! You just need to remember two things about the result (the coefficient):

Rule 1: Ignore the Negative Sign

Because of the Law of Demand (price and quantity move in opposite directions), the PED calculation will always give you a negative number. Economists simply ignore the negative sign when interpreting the result, as we are only interested in the *magnitude* (size) of the responsiveness.

Rule 2: Interpreting the Coefficient

The result (the coefficient) tells us the type of demand:

Case A: Elastic Demand (PED > 1)

  • The percentage change in Quantity Demanded is greater than the percentage change in Price.
  • The coefficient is greater than 1 (e.g., 1.5, 2.0, 4.8).
  • Consumers are highly responsive to price changes.

Case B: Inelastic Demand (PED < 1)

  • The percentage change in Quantity Demanded is less than the percentage change in Price.
  • The coefficient is between 0 and 1 (e.g., 0.5, 0.25, 0.9).
  • Consumers are not very responsive to price changes.

Case C: Unitary Elasticity (PED = 1)

  • The percentage change in Quantity Demanded is equal to the percentage change in Price (e.g., if price rises by 10%, demand falls by exactly 10%).
Step-by-Step Example (Numerical Interpretation)

If a calculation results in PED = 2.5:

  1. Is it greater than 1? Yes.
  2. Therefore, demand is elastic.
  3. Interpretation: For every 1% change in price, the quantity demanded changes by 2.5%.

If a calculation results in PED = 0.4:

  1. Is it less than 1? Yes.
  2. Therefore, demand is inelastic.
  3. Interpretation: For every 1% change in price, the quantity demanded changes by only 0.4%.

3. Visualizing Elastic and Inelastic Demand

We can show the difference between elastic and inelastic demand by looking at the slope (steepness) of the demand curve.

A. Elastic Demand Curve (PED > 1)

An elastic demand curve is relatively flatter.

  • The flatter the curve, the more sensitive the consumers are.
  • Imagine a very small vertical movement (price change) causing a very large horizontal movement (quantity change).
  • Think of it being easy to "stretch" the curve horizontally.

B. Inelastic Demand Curve (PED < 1)

An inelastic demand curve is relatively steeper.

  • The steeper the curve, the less sensitive the consumers are.
  • Imagine a large vertical movement (price change) causing only a small horizontal movement (quantity change).
  • Think of it being like a steep mountain—hard to change the quantity demanded.

Memory Aid:

  • Elastic is Extended (Flatter).
  • InElastic is StEEp.

C. Extreme Cases (For context only)

If PED = 0 (Perfectly Inelastic), the demand curve is a vertical line. Quantity demanded never changes, no matter the price. (Example: A life-saving medicine with no substitutes.)

If PED = Infinity (Perfectly Elastic), the demand curve is a horizontal line. Any increase in price means demand immediately drops to zero. (This is theoretical for individual firms in perfectly competitive markets).

4. Determinants of PED: What Makes Demand Elastic or Inelastic? (Syllabus 2.7.3)

Why is the demand for milk inelastic, but the demand for a specific brand of smartphone highly elastic? The responsiveness of demand depends on several factors:

1. Availability of Substitutes (Most Important)

If a good has many close substitutes, demand will be elastic. If the price goes up, consumers can easily switch to another product.

  • Example: Coca-Cola. If the price of Coke rises significantly, people switch easily to Pepsi or another soft drink. (Elastic)

If a good has few or no close substitutes, demand will be inelastic. Consumers have no alternative but to buy the product even if the price rises.

  • Example: Petrol (Gasoline). If the price rises, you still need it to drive to work. (Inelastic, especially in the short term).

2. Nature of the Good (Necessity vs. Luxury)

  • Necessities: Goods we must buy, like basic food (rice, salt) or medical care. Demand is usually inelastic.
  • Luxuries: Non-essential goods, like expensive jewellery or designer shoes. Demand is usually elastic, as we can easily live without them if the price increases.

3. Proportion of Income Spent

If the good takes up a tiny fraction of your total income, demand tends to be inelastic. You barely notice the price change.

  • Example: The price of a box of matches or a packet of salt. If the price doubles, you still buy it.

If the good takes up a large proportion of your income (like a new car or rent), demand tends to be elastic. A price increase has a major impact on your budget.

4. Time Period

Demand is usually more inelastic in the short run and more elastic in the long run.

  • Why? It takes time for consumers to find alternatives.
  • Example: If the price of electricity goes up today, you can't immediately change your heating system. (Inelastic). Over several years, you might install solar panels or buy a hybrid car. (More Elastic).

5. Habit and Addiction

Goods that are addictive or consumed out of habit (e.g., cigarettes, specific brands of coffee) tend to have inelastic demand, as consumers find it difficult to stop buying them.

Key Takeaway

The more options consumers have, the more elastic the demand. The fewer options they have (e.g., for necessities), the more inelastic the demand.

5. PED and Total Revenue (Syllabus 2.7.4)

This is the most important application of PED for producers!

Total Revenue (TR) is the total amount of money a firm earns from sales.

\[ \text{Total Revenue} = \text{Price} \times \text{Quantity Sold} \]

Firms need to know their PED to decide whether to increase or decrease prices to maximize their revenue.

The Relationship Rule:

Case 1: Dealing with Inelastic Demand (PED < 1)

When demand is inelastic, consumers are not sensitive to price changes.

  • If Price Increases: Quantity demanded falls by a smaller percentage. TR Rises.
  • If Price Decreases: Quantity demanded rises by a smaller percentage. TR Falls.

Conclusion for Inelastic Goods: To increase revenue, the firm should increase the price. (Example: Public transport fares).

Case 2: Dealing with Elastic Demand (PED > 1)

When demand is elastic, consumers are very sensitive to price changes.

  • If Price Increases: Quantity demanded falls by a larger percentage. TR Falls.
  • If Price Decreases: Quantity demanded rises by a larger percentage. TR Rises.

Conclusion for Elastic Goods: To increase revenue, the firm should decrease the price. (Example: Discount clothing stores running sales).

Case 3: Unitary Elasticity (PED = 1)

If demand is unitary, any price change results in an equal and opposite change in quantity demanded, so Total Revenue remains unchanged.

Common Mistake to Avoid:
Students often confuse Total Revenue with Profit. Total Revenue is just the money coming in (P x Q). Profit is Revenue minus Costs (TR - TC). PED only helps firms manage their revenue.

6. Significance of PED for Decision Makers (Syllabus 2.7.5)

The PED concept is vital for three main groups in the economy:

1. Significance for Producers (Firms)

  • Pricing Strategy: Firms use PED estimates to determine if a price increase will boost revenue (if demand is inelastic) or kill revenue (if demand is elastic).
  • Marketing: Firms try to make their demand more inelastic by promoting brand loyalty or unique features, reducing the availability of close substitutes in the consumer's mind.
  • Investment Decisions: If a product has highly elastic demand, firms may invest more in cost-saving technology to reduce price and gain market share, rather than relying on high prices.

2. Significance for the Government

  • Taxation (Indirect Taxes): Governments often place high indirect taxes (like excise duties) on goods with inelastic demand (e.g., cigarettes, alcohol, fuel).
    • If demand is inelastic, consumers will continue buying the product even with the tax, meaning the government collects high revenue, and the tax burden (incidence) falls mainly on the consumer.
  • Subsidies: Governments may subsidize essential goods (which often have inelastic demand) to reduce the price to consumers, knowing that the lower price will not deter purchase but makes the necessity more affordable.
  • Macroeconomic Policy: Governments need to know the PED for exports and imports when managing exchange rate fluctuations (a concept you will revisit later in the course!).

3. Significance for Consumers

  • PED helps consumers understand their bargaining power. If the goods they buy are elastic (many substitutes), they have more choice and power.
  • If the goods they buy are inelastic (necessities, few substitutes), they are vulnerable to price increases and taxation, as they have little option but to continue buying.
Did You Know?

The reason governments can rely on fuel taxes and tobacco duties for stable revenue is precisely because the PED for these goods is very low (inelastic) due to habit, addiction, and necessity.

Chapter Summary: Key Takeaways

PED is a measure of consumer responsiveness to price changes.

PED > 1 (Elastic): Sensitive consumers, flatter curve. Price cuts boost revenue.

PED < 1 (Inelastic): Insensitive consumers, steeper curve. Price hikes boost revenue.

The main determinant is the availability of substitutes. The concept guides producers in pricing and governments in effective taxation policies.