EC9: Price Elasticity
Price elasticity of demand and supply: calculating PED and PES, factors affecting elasticity, and implications for producers and consumers.
Price Elasticity
Price elasticity of demand and supply: calculating PED and PES, factors affecting elasticity, and implications for producers and consumers.
Key Fact: PED = % change in quantity demanded / % change in price. |PED| > 1 = elastic; |PED| < 1 = inelastic.
Key Fact: Factors affecting PED: substitutes (more = more elastic), necessity vs luxury (necessities = inelastic), proportion of income (larger = more elastic), time (more elastic long-term).
Key Fact: PES = % change in quantity supplied / % change in price. PES > 1 = elastic supply; PES < 1 = inelastic. More elastic with spare capacity, easy switching, and longer time.
Key Fact: If demand is inelastic, raising price increases revenue (petrol, cigarettes). If elastic, raising price reduces revenue.
Key Fact: Inelastic demand for essentials means consumers bear the burden of price rises — hence government intervention (price caps, subsidies).
📋 Key Vocabulary and Concepts
For Price Elasticity, you must know:
- Price elasticity of demand
- PED
- Price elasticity of supply
- PES
- Elastic
- Inelastic
- Unit elasticity
- Substitutes
- Necessity
- Luxury
❓ Practice Questions
Q1: Calculate PED if price rises from £10 to £12 and quantity falls from 100 to 80. Is demand elastic or inelastic?
Q2: Explain three factors that make demand price inelastic.
Q3: Evaluate why understanding PED is important for a business setting pricing strategy.
✅ Answers
- %ΔP = (12-10)/10 × 100 = 20%. %ΔQ = (80-100)/100 × 100 = -20%. PED = -20%/20% = -1.0. Absolute value = 1 = unit elasticity. Total revenue stays the same.
- Three factors: (1) Few substitutes (insulin for diabetics). (2) Necessity (bread, electricity, water). (3) Small proportion of income (salt, matches — price changes are insignificant).
- If demand is inelastic, raise prices — quantity falls less than price rises, increasing revenue. If elastic, lower prices — quantity rises more than price falls, increasing revenue. PED varies by time period, market segment, and price level.
🎯 Exam Tips
- Always show the PED formula and working: (%ΔQd) / (%ΔP).
- PED is NEGATIVE (law of demand), but we use the ABSOLUTE value for comparison.
- Use the TOTAL REVENUE TEST: price rises and revenue rises = inelastic. Price rises and revenue falls = elastic.
📝 Exam Technique
Economics Exam Tips:
When applying elasticity, use the STIP framework: Substitutes available? Time period? Income proportion? Product type (necessity or luxury)? Elasticity determines whether price changes help or hurt producers and consumers.
When applying elasticity, use the STIP framework: Substitutes available? Time period? Income proportion? Product type (necessity or luxury)? Elasticity determines whether price changes help or hurt producers and consumers.
⚠️ Common Errors
Watch Out!
Students often make mistakes here. Wrong: If a product is a necessity, its demand is always perfectly inelastic. Correct: Necessities have inelastic demand but rarely perfectly inelastic (PED = 0). Even essential goods show some response: if water prices rise dramatically, people use less for gardens. Perfectly inelastic demand is a theoretical extreme, not real for most goods.
✍️ Model Answer
Full-Mark Response
Evaluate whether a government should tax goods with inelastic demand or elastic demand to raise the most revenue.
A grade 9 response will: taxing inelastic goods raises more revenue (quantity barely falls); taxing elastic goods raises little (consumers switch); equity issue (inelastic goods like energy hit the poor hardest); conclude: tax inelastic goods for revenue efficiency but use revenue to fund progressive spending for equity.
📊 AO Deep Dive
Assessment Objective Focus: Price Elasticity
AO1 — Knowledge: Demonstrate knowledge of Price Elasticity with precise business/economic terminology. Define key terms and state accurate factual information.
AO2 — Application: Apply knowledge of Price Elasticity to business scenarios and case studies. Use quantitative data where relevant to support your points.
AO3 — Analysis & Evaluation: Analyse and evaluate Price Elasticity by considering trade-offs, weighing costs against benefits, and reaching a reasoned judgement. Use connectives to show chains of reasoning.
Detailed Notes: Elasticity
Price Elasticity of Demand (PED)
Price elasticity of demand measures how responsive quantity demanded is to a change in price. It is calculated as: PED = percentage change in quantity demanded / percentage change in price. If PED is greater than 1 (ignoring the minus sign), demand is elastic — a price change causes a proportionally larger change in quantity demanded. If PED is less than 1, demand is inelastic — quantity demanded changes proportionally less than price. The sign is always negative (due to the law of demand), but economists usually ignore the minus sign and focus on the absolute value.
PED depends on several factors: the availability of substitutes (more substitutes = more elastic), the proportion of income spent (larger share = more elastic), whether the good is a necessity or luxury (necessities = inelastic, luxuries = elastic), and the time period (demand becomes more elastic over time as consumers find alternatives). For GCSE, understanding these determinants is essential for explaining why some goods have elastic demand and others do not.
Real-World Example
UK demand for rail commuting is relatively inelastic (PED approximately 0.3–0.6) because many commuters have no realistic alternative — driving into central London is expensive and slow, and buses are not a practical substitute for long-distance travel. However, demand for first-class rail travel is more elastic because it is a luxury with a closer substitute (standard class). This is why rail companies can raise commuter fares above inflation each year without losing many passengers, whilst first-class fares are more competitive.
Price Elasticity of Supply (PES) and Income Elasticity of Demand (YED)
Price elasticity of supply measures how responsive quantity supplied is to a price change: PES = percentage change in quantity supplied / percentage change in price. Supply is elastic if PES is greater than 1 (firms can quickly increase output) and inelastic if less than 1 (firms cannot easily increase output). Key determinants include spare capacity, stock levels, ease of switching production, and time period. UK agriculture has inelastic supply because crops take months to grow; UK software development has more elastic supply because output can be scaled more quickly.
Income elasticity of demand (YED) measures how demand responds to income changes: YED = percentage change in quantity demanded / percentage change in income. Normal goods have positive YED (demand rises with income); inferior goods have negative YED (demand falls as income rises). Luxury goods have YED greater than 1 (demand rises proportionally more than income). Understanding YED is crucial for explaining how economic growth and recessions affect different markets — demand for luxury goods like premium cars falls sharply in a recession (income elastic), whilst demand for basic food is barely affected (income inelastic).
Real-World Example
During the 2008–2009 UK recession, GDP fell by approximately 6% and household incomes dropped. Demand for luxury goods like Jaguar cars and premium restaurant meals fell sharply (high positive YED), whilst demand for supermarket own-brand products and discount stores like Poundland actually increased (negative YED — these are inferior goods). This pattern was repeated during the 2020 COVID recession, with Aldi and Lidl gaining market share whilst Waitrose and M&S Food lost customers.
Applying Elasticity to Business and Government Decisions
Elasticity is not just a theoretical concept — it has real practical applications. Firms use PED to set pricing strategy: if demand is inelastic, a price increase will raise total revenue (because the loss in quantity sold is proportionally less than the gain in price). If demand is elastic, a price increase will reduce total revenue. This explains why the UK government taxes cigarettes and alcohol heavily (inelastic demand means tax increases raise substantial revenue without destroying the market) and why retailers discount goods with elastic demand during sales (a price cut increases quantity sold proportionally more, raising total revenue).
Governments use YED to predict which industries will grow as the economy grows (those with high positive YED) and which will decline (inferior goods). They use PED to estimate the impact of indirect taxes on consumers vs producers — if demand is inelastic, most of the tax burden falls on consumers because they cannot easily switch away from the product. Understanding who bears the burden of a tax (tax incidence) is essential for evaluating whether taxes are fair and effective.
Real-World Example
The UK government charges approximately 80% tax on a pack of cigarettes. Despite this enormous tax, UK cigarette consumption has only fallen by about 25% over the past decade — confirming that demand is highly inelastic. The tax raises around £10 billion per year for the Treasury. However, the inelastic demand also means the tax burden falls heavily on smokers, who are disproportionately from lower-income groups, making the tax regressive. This trade-off between revenue raising, health improvement and fairness is a classic elasticity-based policy dilemma.
Comparison: Types of Elasticity
| Type | Measures | Formula | Elastic Value | Inelastic Value | UK Example |
|---|---|---|---|---|---|
| PED | Responsiveness of demand to price | % change in Qd / % change in P | Greater than 1 | Less than 1 | Restaurant meals (elastic) vs petrol (inelastic) |
| PES | Responsiveness of supply to price | % change in Qs / % change in P | Greater than 1 | Less than 1 | Software (elastic) vs housing (inelastic) |
| YED | Responsiveness of demand to income | % change in Qd / % change in Y | Greater than 1 (luxury) | Less than 1 (necessity) | Designer clothing vs basic food |
| XED | Responsiveness of demand to other good's price | % change in Qd of A / % change in P of B | Positive (substitutes) | Negative (complements) | Butter/margarine (+) vs printers/ink (-) |
Additional Practice Questions
Q1: Explain why a firm selling a product with price inelastic demand might choose to increase its price, and evaluate whether this strategy would always be successful.
Q2: Using the concept of income elasticity of demand, explain how an economic recession in the UK would affect different types of businesses.
Additional Model Answers
- A firm selling a product with inelastic demand may increase its price because total revenue will rise — since quantity demanded falls proportionally less than the price rises, the firm earns more from the higher price than it loses from fewer sales. For example, a UK rail company raising season ticket prices by 5% when PED is 0.4 would expect quantity demanded to fall by only 2%, so total revenue increases. However, this strategy is not always successful. If the price rise is very large, even inelastic demand will eventually lose enough customers to reduce revenue. Competitors may enter the market if prices create profit opportunities (making demand more elastic over time). Consumer backlash and regulatory intervention are also risks — the UK government has investigated rail fare increases, and the Competition and Markets Authority can act against firms abusing market power. Additionally, if the firm also faces rising costs, the increased revenue may not translate into higher profit. The strategy works best in the short run with genuinely inelastic demand and limited competition.
- An economic recession reduces household incomes. Businesses selling normal goods with high positive YED (luxuries) will see demand fall sharply — for example, UK premium car dealerships, high-end restaurants, and luxury fashion retailers typically suffer significant revenue declines during recessions. Businesses selling necessity goods with low positive YED (0 to 1) will see demand fall only slightly — supermarkets selling basic food and household essentials are relatively resilient. Businesses selling inferior goods with negative YED will see demand increase — discount retailers like Aldi and B&M, own-brand product ranges, and budget bus services typically gain customers during recessions as consumers trade down. The 2008–2009 recession demonstrated this clearly: luxury goods sales in the UK fell by over 20%, whilst discount retailer Poundland's sales actually grew, opening 50 new stores during the recession period.
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🎬 Video Resources
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