Chapter 3.3: Price Elasticity of Demand – Fast Recap 100% Pass IB Exams

Elasticity

Elasticity is the measure of responsiveness of a variable to changes in price or any of the variable’s determinants.

Elastic is when the relative change in demand or supply is greater than the change in price.

Inelastic is when the relative change in demand or supply is less than the change in price.

Price Elasticity of Demand

Price Elasticity of Demand is the measure of responsiveness of the quantity of a good demanded to changes in its price. It is basically by how much quantity responds to change in price.

Formula

The formula can be abbreviated into:

Simplifying the above formula can be rewritten as:

The Sign of PED (+ / -)

Remember, when calculating the PED, it is not in percentage (there are no units) and the common practice is to drop the ‘-‘ sign and consider PED as a positive number. In maths, this is called as taking the absolute value, to avoid confusion when making assumptions and comparisons between different values of PED.

For example, PED = 2 or PED = -3.

Example Question

Question 1

Consumers buy 6000 TVs when the price is $255 per unit, and they buy 5000 TVs when the price is $300. Calculate the PED and state whether it is elastic or inelastic.

or 1.33 since we drop the ‘-‘ sign. Therefore, PED for TVs is 1.3, and we can say that the product has a price elastic demand.

Question 2

If we know PED and the percentage change in P, we can calculate the percentage change in Q. Suppose PED = 1.25 and price of good X increases by 12%. Calculate the percentage change in Q demanded:

Question 3

We can also calculate the percentage change in P if we know PED and the percentage change in Q demanded. Suppose PED = 0.80 and quantity of good Y demanded falls by 16%. Calculate the percentage change in P:

Note: here we have used ‘-‘ signs in the calculation to show decreases, however, this is not necessary since the final elasticity value is taken as a positive or absolute number.

Characteristics of Price Elasticity of Demand

Value of PED	Classification	Interpretation
Frequently encountered cases
0 < PED < 1 (greater than zero and less than one)	price inelastic demand	quantity demanded is relatively unresponsive to price
1 < PED < ∞ (greater than 1 and less than infinity)	price elastic demand	quantity demanded is relatively responsive to price
Special cases: constant PED along the length of the demand curve
PED = 1	unit elastic demand	percentage change in quantity demanded equals percentage change in price
PED = 0	perfectly inelastic demand	quantity demanded is completely unresponsive to price
PED = ∞	perfectly elastic demand	quantity demanded is infinitely responsive to price

Demand Curves and PED

Frequently encountered cases

Note: The variety of demand curves and their PEDs suggest that the flatter the demand curve, the more elastic the demand (higher PED). The steeper the demand curve, the more inelastic the demand (lower PED).

Special cases

Determinants of Price Elasticity of Demand

Number and closeness of substitutes

The greater the number of substitute products and the more closely substitutable those products are, the more we would expect people to switch away from a certain product when its price increases or towards that same product if its price decreases.

In summary, the more substitutes a good or service has, the more elastic is its demand.

If the price of a good with many substitutes increases, consumers can switch to other substitutes which leads to in a relatively large decrease (responsiveness) in quantity demanded.

For example, the case of canned drinks where there are many types of cola, iced tea, and fruit juice so a small change in price could see quite large changes in what people are able and willing to purchase.

Other substitutability issues to consider include:

• the quality and accessibility of information that consumers have about products that are available to satisfy particular wants and needs
• the degree to which people consider the product to be a necessity
• the addictive properties of the product, i.e. whether the product is habit-forming
• the brand image of the product

Necessities are goods or services we consider to be essential or necessary in our lives; we cannot do without them. The demand for necessities is less elastic than the demand for luxuries. For example, the demand for medications is very inelastic because people’s health depend on them, therefore quantity demanded is not very responsive to changes in price.

A special case of necessity is a consumer’s addiction to a good. The greater the degree of addiction to a substance e.g. alcohol, cigarettes and so on, the more inelastic is the demand. A price increase will not bring forth a significant reduction in quantity demanded if one is severely addicted.

Luxuries are not necessary or essential. For example, the demand for diamond rings is elastic as most people view them as luxuries.

Note: In general, the more necessary a good, the less elastic the demand.

Length of time

In the short term, perhaps weeks or months, consumers may find it hard to change their spending patterns.

However, if the price of a product goes up and stays up, then in the long run, consumers have time to consider whether they really want the good or get information on the availability of alternatives to the good in question. So the PED will likely become more elastic or increase over time.

For example, if there is an increase in the price of heating oil, consumers can do little to switch to other forms of heating in a short period of time, and therefore demand for heating oil tends to be inelastic over short periods. But as time passes, they can switch to other heating systems, such as gas, or install a newer insulation and demand for heating oil becomes more elastic.

Proportion of income spent on a good

A rise in price will reduce the purchasing power of a person’s income and hence the ability to pay.

The larger the proportion of income needed to buy a good, the more elastic the demand, other things being equal (ceteris paribus).

For example, a pen takes up a very small proportion of one’s income, whereas a car takes up a much larger proportion. For the same percentage increase in the price of pens and in the price of cars, the change in quantity demanded is likely to be greater in the case of the car than in the case of pens.

Applications of Price Elasticity of Demand

PED and Total Revenue

Demand is Elastic (PED >1 )

When demand is elastic, an increase in price causes a fall in total revenue, while a decrease in price causes a rise in total revenue.

To see why, consider that if demand is elastic, an increase in price results in a proportionately larger decrease in quantity demanded. For example, if price rises by 10% quantity demanded will fall by more than 10%. The decrease in quantity has a bigger impact on total revenue; therefore, total revenue falls. If price decrease, a 10% price fall results in a larger than 10% increase in quantity demanded, and total revenue increases.

Demand is Inelastic (PED < 1)

When demand is inelastic, an increase in price causes an increase in total revenue, while a decrease in price causes a fall in total revenue.

If demand inelastic, an increase in price causes a proportionately smaller decrease in quantity demanded. For example, a 10% price increase produces a smaller than 10% decrease in quantity demanded, and total revenue rises. If prices falls, a percentage price decrease gives rise to a smaller percentage increase in quantity demanded and total revenue falls. In both cases, the effect on total revenue of the change in price is larger than the effect of the change in quantity.

Demand is Unit Elastic (PED = 1)

When demand is unit elastic, a change in price does not cause any change in total revenue.

A unit elastic demand means that the percentage change in quantity is equal to the percentage change in price, and total revenue remains constant.

Using Diagrams To Illustrate PED and The Effects of Price Changes On Total Revenue

Elastic demand: as Price increases Total Revenue falls: P and TR change in opposite direction

Inelastic demand: as Price increases Total Revenue increases: P and TR change in same direction

Unitary PED: any change in Price leaves Total Revenue unchanged

PED and Firms Pricing Decisions (Indirect Taxes)

If a business wants to increase total revenue, it must decrease its price if demand is elastic. However, it must increase its price if demand is inelastic. If demand is unit elastic, the firm is unable to change its total revenue by changing its price.

Inelastic Demand

Indirect taxes are imposed on goods and services to discourage the consumption and production of harmful products (products with negative externalities) e.g. tobacco, alcohol, and environmentally damaging goods. If governments are interested in increasing their tax revenues, they must consider the PED of the goods to be taxed for the following reason.

The lower the price elasticity of demand for the taxed good, the greater the government tax revenues.

When tax is imposed on a good, it has the effect of shifting the supply curve upward. The reason is that for every level of output the firm is willing and able to supply to the market, it must receive a price that is higher than the original price by the amount of the tax.

The shaded area below represents the governments tax revenue (P_c – P_p), obtained by multiplying the amount of tax per unit times the number of units, or quantity Q_t.

Before tax, the equilibrium was at P*Q*. An indirect tax decreases supply from S₁ to S₂. At the new equilibrium point, P_cQ_t consumers are paying a higher price of P _c and quantity demanded and supplied has declined to Q_t . However, producers need to give the value of the tax to the government, so producers only receive P_p (i.e. P_c – tax).

Consumers pay a larger portion of tax (P_c – P*) x Q_t. Producers pay a smaller portion of tax (P* – P_p) x Q_t. When demand is inelastic, consumers tend to pay more of the tax. Producers are confident that they can raise the price of the good for consumers without losing that much sales when demand is inelastic.

Elastic Demand

When demand is elastic, producers bear more tax burden than consumers.

The shaded area above represents the governments tax revenue (P_c – P_p), obtained by multiplying the amount of tax per unit times the number of units, or quantity Q_t.

Before the tax, the equilibrium was at P*Q*. An indirect tax decreases supply from S₁ to S₂. At the new equilibrium point, P_cQ_t , consumers are paying a higher price of P _c and quantity demanded and supplied has declined to Q_t. However, producers need to give the value of the tax to the government, so producers only receive P_p (i.e. P_c – tax).

Consumers pay a smaller portion of tax (P_c – P*) x Q_t. Producers pay a larger portion of tax (P* – P_p) x Q_t. When demand is elastic, consumers tend to pay less of the tax. Producers do not wish to raise the price of the good to cover the tax, because they know that it will lead to a huge decrease in quantity demanded. Therefore, producers are more willing to bear more of the tax when demand is elastic.

Simple Review Questions

1. Explain the meaning of price elasticity of demand.
2. State why we treat PED as if it were positive, even though it is usually negative.
3. It is observed that when the price of pizzas is $16 per pizza, 100 pizza are sold; when the price falls to $12 per pizza, 120 pizzas are sold. Calculate price elasticity of demand.
4. A 10% increase in the price of a particular good gives rise to an 8% decrease in quantity bought. Calculate the price elasticity of demand.
5. The PED for good X is 0.8. If the price of good X increased by 15%, calculate the percentage decrease in quantity demanded.
6. The PED of good Y is 1.5. If quantity of good Y increases by 30%, calculate the percentage decrease in the price of good Y.
7. Specify the value for each of the following PEDs and show, using diagrams, the shape of the demand curve that corresponds to each one:
   – perfectly elastic demand
   – unit elastic demand
   – perfectly inelastic demand
   – inelastic demand
   – elastic demand
8. Provide examples of goods likely to have demand that is
   – elastic
   – inelastic
9. Using diagrams, discuss how a firm’s knowledge of price elasticity of demand for its product can help it in its pricing decisions.
10. Calculate the change in total revenue when price increases from $1 to $2. Comment on the size of PED for a price change from $1 to $2.
11. The government would like to levy indirect taxes on certain goods to raise tax revenue. Using diagrams, explain how price elasticity of demand can help it decide which products it should tax.
12. Suppose flooding destroys a substantial portion of this season’s crop. Using diagrams, explain what is likely to happen to farmers’ revenues, assuming the demand for the product they produce is inelastic.
13. Using examples, explain why many primary commodities have a relatively low PED while many manufactured products have a relatively high PED.

Past Paper Review Questions

Command Terms

References

• https://www.amazon.in/Economics-Diploma-Coursebook-Digital-Access/dp/1108847064
• https://www.amazon.com/Economics-Diploma-CD-ROM-Ellie-Tragakes/dp/0521186404
• https://www.cambridge.org/us/education/subject/business-and-economics/economics/cambridge-international-and-a-level-economics-3rd-edition/cambridge-international-as-and-a-level-economics-3rd-edition-coursebook-cd-rom?isbn=9781107679511
• https://www.ibdeconomics.com/uploads/1/1/7/5/11758934/ib_economics_-_command_terms.pdf
• https://kognity.com/products/ibdp/

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Macroeconomics Subtopic 3.2 – VARIATIONS IN ECONOMIC ACTIVITY—AGGREGATE DEMAND AND AGGREGATE SUPPLY – Best Revision Guide