Economics (9214) | Price elasticity of demand

📚 Economics 9214 Study Notes: Price Elasticity of Demand (PED)

Welcome to the World of Price Sensitivity!

Hi there! This chapter is all about understanding how consumers react when prices change. In the section "How prices are determined," knowing this reaction is vital because it helps businesses decide what price to set and helps governments understand the impact of taxes.

Don’t worry if the term elasticity sounds complicated—it just means how sensitive something is. We are measuring how sensitive demand is to a change in price. Ready to dive in? Let’s go!

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1. Defining Price Elasticity of Demand (PED)

The core idea of PED is simple: When the price of a good goes up, the quantity demanded usually goes down (that’s the Law of Demand!). But how much does it go down? A little bit? Or a huge amount?

What is PED?

Price Elasticity of Demand (PED) measures the responsiveness (sensitivity) of the quantity demanded for a good or service following a change in its price.

Think of it this way: Imagine hitting a tennis ball. If the ball is elastic, it bounces really high (responsive). If it is inelastic (like a dense rock), it barely bounces at all (unresponsive).

• High PED (Elastic): Consumers are very responsive. A small price change leads to a large change in quantity demanded.
• Low PED (Inelastic): Consumers are not very responsive. A large price change leads to only a small change in quantity demanded.

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2. The PED Formula and Interpretation

To measure this responsiveness precisely, economists use a simple ratio formula.

The Formula

We calculate PED using percentage changes because it allows us to compare different products (like comparing the demand for expensive cars versus cheap chewing gum) fairly.

PED Formula:

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

Step-by-Step Trick: Don’t worry about the minus sign!

• Because price and quantity always move in opposite directions (Law of Demand), the PED result is technically always negative.
• In International GCSE, we always look at the absolute value (the size or magnitude) of the number, so you can ignore the minus sign completely when interpreting the result.

Interpreting the Coefficient (The Result)

The value you get from the calculation tells you which "type" of demand the product has. The critical number to remember is 1.

Type 1: Elastic Demand (\(PED > 1\))

If the value is greater than 1 (e.g., 2.5 or 1.3), demand is Elastic.

• The percentage change in quantity demanded is greater than the percentage change in price.
• Consumers are very sensitive.
• Analogy: If the price goes up by 10%, demand might drop by 20%.
• Real-World Example: Most luxury goods or products with many close substitutes (like different brands of chocolate or soft drinks).

Type 2: Inelastic Demand (\(PED < 1\))

If the value is less than 1 (e.g., 0.5 or 0.1), demand is Inelastic.

• The percentage change in quantity demanded is less than the percentage change in price.
• Consumers are insensitive or unresponsive.
• Analogy: If the price goes up by 10%, demand might only drop by 2%.
• Real-World Example: Essential items with few substitutes, such as petrol/gasoline, electricity, or life-saving medicines.

Type 3: Unitary Elasticity (\(PED = 1\))

If the value is exactly 1, demand is Unitary Elastic.

• The percentage change in quantity demanded is exactly equal to the percentage change in price. (If price rises 10%, demand falls 10%).

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3. What Determines PED? (The Factors)

Why is demand for medicine inelastic, while demand for a specific brand of cereal is elastic? It all depends on four key factors that influence how easily consumers can avoid buying the product when the price rises.

Factor 1: Availability of Substitutes

This is usually the most important factor.

• Lots of substitutes = Elastic Demand: If the price of Brand A coffee goes up, consumers can easily switch to Brand B coffee or tea. The response is large.
• Few (or no) substitutes = Inelastic Demand: If the price of tap water goes up, what are you going to switch to? Nothing viable. The response is small.

Factor 2: Necessity vs. Luxury

How important is the item to your survival or basic functioning?

• Necessities = Inelastic Demand: We need them regardless of price. Example: Basic food items, essential housing.
• Luxuries = Elastic Demand: We can easily postpone buying them if the price rises. Example: Expensive holidays, designer clothing.

Factor 3: Proportion of Income Spent on the Good

How big a chunk of your weekly budget does this item take up?

• Small Proportion = Inelastic Demand: If the price of chewing gum doubles from 50p to £1, it’s unlikely to significantly change your buying habits, because it’s such a tiny part of your income.
• Large Proportion = Elastic Demand: If the price of a new car rises by 10%, that’s potentially thousands of pounds—you will likely search for alternatives or delay the purchase.

Factor 4: Time Period

Consumers generally need time to find alternatives or adjust their habits.

• Short Run (Immediately) = More Inelastic: If petrol prices spike tonight, you still need to drive to school/work tomorrow. You can't change your car or location instantly.
• Long Run (Over time) = More Elastic: If petrol prices stay high for two years, you might buy a smaller, more fuel-efficient car, start taking the bus, or move closer to work. You have found substitutes over time.

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4. The Importance of PED for Decision-Making

Understanding elasticity is not just academic; it is crucial for real-world decision-making by both businesses and governments.

A. PED for Firms (Total Revenue)

For a business, the most important application of PED is figuring out what happens to Total Revenue (TR) when they change the price.

Total Revenue is simply the total money earned from sales: \(TR = \text{Price} \times \text{Quantity}\).

Scenario 1: Elastic Demand (\(PED > 1\))

If demand is elastic, consumers are very sensitive.

• If the firm raises the price, the quantity demanded drops dramatically. Total Revenue will fall.
• If the firm lowers the price, the quantity demanded increases dramatically. Total Revenue will rise.
• Key Takeaway for Elastic Goods: Price cuts are often good for total revenue.

Scenario 2: Inelastic Demand (\(PED < 1\))

If demand is inelastic, consumers are not sensitive.

• If the firm raises the price, quantity demanded drops only a little. Total Revenue will rise.
• If the firm lowers the price, quantity demanded increases only a little. Total Revenue will fall.
• Key Takeaway for Inelastic Goods: Price increases are often good for total revenue. (This is why utilities and drug companies can raise prices successfully).

Did you know? Movie theatres and airlines often price their tickets differently for different days/times (peak vs. off-peak) based on the estimated elasticity of the demand for those specific slots!

B. PED for Government (Taxation)

Governments use elasticity when deciding which goods to tax (indirect taxes). They have two goals: raising revenue and discouraging consumption.

Goal 1: Maximising Tax Revenue

• To raise reliable revenue, the government will tax goods with Inelastic Demand (like tobacco, alcohol, or fuel).
• Why? Because even if the tax makes the price higher, consumers won't stop buying it, so the government’s tax income is guaranteed.

Goal 2: Discouraging Consumption (De-Merit Goods)

• To truly discourage the consumption of a de-merit good (like sugary drinks), the government needs the price rise to cause a large drop in demand.
• Therefore, indirect taxes are most effective at reducing consumption if the good has Elastic Demand (or at least becomes more elastic over time).

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Summary and Final Thought

Great job making it through this core concept! PED explains why the price of your favourite chocolate bar might change often, but the price of your electricity bill rarely falls. Keep practising those scenarios!