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IB DP Economics Study Notes

2.5.1 Price Elasticity of Demand (PED)

Price Elasticity of Demand, often abbreviated as PED, is a central concept in microeconomics. It gauges the sensitivity of the quantity demanded of a good or service to a change in its price, providing insights into consumer behaviour and market dynamics.

Definition

PED is a measure that captures the responsiveness of the quantity demanded of a product to its price change. It's a dimensionless measure, which means it doesn't have units, making it easier to compare across various goods and services. The formula for PED is:

PED = Percentage change in quantity demanded / Percentage change in price

  • Elastic Demand: When ∣PED∣>1, it indicates that the quantity demanded is highly sensitive to price changes. A minor alteration in price results in a proportionally larger shift in quantity demanded.
Graph of price elastic demand

A graph illustrating price elastic demand with |PED|>1.

Image courtesy of dineshbakshi

  • Unitary Elastic Demand: If ∣PED∣=1, it means the percentage shift in quantity demanded is precisely equal to the percentage change in price. Here, total revenue remains unchanged when the price alters.
Graph of unitary price elastic demand

A graph illustrating unitary price elastic demand with |PED|=1.

Image courtesy of klublr

  • Inelastic Demand: When ∣PED∣<1, the quantity demanded is less affected by price changes. Even a significant price change results in a proportionally smaller shift in quantity demanded.

Understanding the non-price determinants of demand can further elaborate on how factors other than price affect demand elasticity.

Graph of price inelastic demand

A graph illustrating price inelastic demand with |PED|<1.

Image courtesy of dineshbakshi

Calculation

Calculating PED involves a few steps, which are outlined below:

1. Determine the Initial and New Prices and Quantities: This is the data before and after a price change.

2. Compute the Percentage Change in Price and Quantity:

  • Percentage change in price = New Price - Initial Price / Initial Price x 100 ​×100
  • Percentage change in quantity =New Quantity - Initial Quantity​ / Initial Quantity x 100

3. Divide the Percentage Change in Quantity by the Percentage Change in Price:

  • PED= Percentage change in quantity demanded / Percentage change in price

It's worth noting that PED is usually negative due to the law of supply (as price increases, quantity demanded decreases). However, we often refer to the absolute value to discuss its magnitude.

IB Economics Tutor Tip: Mastering PED calculations enables you to predict market reactions to price changes, a crucial skill for evaluating the impact of economic policies and business strategies.

Determinants of PED

The elasticity of demand isn't uniform across products or services. Several factors influence whether demand is elastic or inelastic:

1. Substitutability: The availability of substitutes plays a pivotal role. The more substitutes available, the more elastic the demand. If a product's price rises and there are many substitutes, consumers can easily switch, leading to a larger decrease in quantity demanded.

2. Necessity vs. Luxury: Essentials generally have inelastic demand. Regardless of price fluctuations, consumers will continue purchasing them. Luxuries, conversely, have more elastic demand. If prices surge, consumers might opt to skip them.

3. Duration of Price Change: Initially, demand might be inelastic because consumers can't swiftly adjust their consumption patterns. But over time, as they seek alternatives or adjust their habits, demand can become more elastic.

4. Proportion of Income Spent: Products that consume a significant portion of a consumer's income tend to have more elastic demand. Even a slight price hike can drastically affect a consumer's purchasing power and decisions.

5. Addictiveness or Habitual Consumption: Items that are addictive or consumed out of habit (like cigarettes or daily coffee) usually have inelastic demand. Despite price hikes, consumers might persist in buying them.

6. Breadth of Definition of a Good: General goods (like food) often have inelastic demand because they include a vast array of products. Specific goods (like tropical fruits) might face more elastic demand due to competition from similar products.

7. Time Horizon: Elasticity can evolve. For some products, demand might be inelastic in the immediate aftermath of a price change but become more elastic over extended periods as consumers discover alternatives or adjust their preferences.

8. Consumer Awareness: If consumers are unaware of price hikes, they might continue purchasing at the same rate, making demand appear inelastic. However, once they become aware, they might reduce consumption, increasing elasticity.

9. Brand Loyalty: Some consumers are incredibly loyal to specific brands. Even if the price of their favourite brand rises, they might continue to buy it, leading to inelastic demand.

10. Availability of Information: If consumers have full information about a product, its substitutes, and prices, they can make informed decisions, leading to more elastic demand. Conversely, limited information can make demand more inelastic.

Implementing taxation can significantly impact PED by altering the price consumers pay and thus their demand elasticity.

Moreover, understanding the definition of externalities is crucial as it affects consumer perception and demand elasticity for goods with significant external effects.

IB Tutor Advice: Practise drawing and interpreting demand curves with different PED values to enhance your ability to quickly assess elasticity in exam scenarios, crucial for data response questions.

In essence, Price Elasticity of Demand offers invaluable insights into consumer behaviour, market dynamics, and the potential impact of pricing strategies. By understanding and analysing the determinants of PED, businesses, economists, and policymakers can make more informed decisions about pricing, market interventions, and economic policies. Additionally, the concept of income elasticity of demand (YED) extends these insights by examining how changes in consumers' income levels affect the quantity demanded.

FAQ

While it's generally believed that luxury goods have elastic demand, there are instances where luxury goods exhibit inelastic demand. This can be due to the prestige or status associated with owning such goods. For high-end luxury brands, consumers often perceive them as unique and irreplaceable, making them less sensitive to price changes. Additionally, for certain affluent consumer segments, the price is not a primary concern, and they might continue purchasing the luxury good regardless of price hikes. In such cases, the luxury good becomes a Veblen good, where higher prices might even increase its appeal due to the exclusivity factor.

In the short run, consumers might not immediately adjust their consumption habits in response to price changes, making demand appear more inelastic. This is because they might not be aware of alternatives, or it might take time to adjust their consumption patterns. However, in the long run, as consumers become more aware of alternatives, have time to adjust their habits, or new products enter the market, demand can become more elastic. For instance, a sudden increase in petrol prices might not drastically reduce consumption immediately, but in the long run, consumers might opt for more fuel-efficient vehicles or alternative modes of transport, making demand more elastic.

Yes, PED can be positive, leading to what's known as a "Giffen good". A Giffen good is a product that sees an increase in quantity demanded as its price rises. This seemingly contradictory behaviour is attributed to the income effect outweighing the substitution effect. For instance, if a staple food item (like bread in a very poor community) sees a price increase, the real income of consumers effectively falls. If no close substitutes are available, and the product is a necessity, consumers might end up buying more of this product and less of more expensive alternatives, leading to a positive PED.

PED plays a crucial role in shaping government policies, particularly in the realm of taxation. Governments often use taxes to achieve certain economic or social objectives. Understanding PED helps in predicting how consumers will react to tax-induced price changes. For goods with inelastic demand, governments can impose higher taxes without significantly affecting consumption levels, ensuring steady tax revenue. This is often seen in the taxation of cigarettes or alcohol. Conversely, for goods with elastic demand, heavy taxation might drastically reduce consumption, leading to potential declines in tax revenue. Thus, governments must consider PED when setting tax rates to ensure they meet revenue and policy objectives.

The concept of Price Elasticity of Demand (PED) is intrinsically linked to a business's total revenue. When demand is elastic (PED > 1), a decrease in price will lead to a proportionally larger increase in quantity demanded, resulting in an increase in total revenue. Conversely, an increase in price will reduce total revenue. For inelastic demand (PED < 1), a price increase will lead to a proportionally smaller decrease in quantity demanded, increasing total revenue, while a price decrease will reduce total revenue. For unitary elastic demand (PED = 1), changes in price do not affect total revenue. Understanding PED helps businesses make strategic pricing decisions to maximise revenue.

Practice Questions

Define the term "Price Elasticity of Demand" (PED) and explain the significance of a product having an elastic demand.

Price Elasticity of Demand (PED) refers to the measure that captures the responsiveness of the quantity demanded of a product to a change in its price. It quantifies how much the quantity demanded changes in response to a given percentage change in price. When a product has an elastic demand, it implies that the quantity demanded is highly sensitive to price changes. This means that a small change in price will lead to a proportionally larger change in quantity demanded. The significance of elastic demand is that businesses need to be cautious with pricing strategies, as price changes can significantly impact revenue and sales volume.

List two determinants of Price Elasticity of Demand and briefly explain how each factor can influence the elasticity of a product.

Two determinants of Price Elasticity of Demand are the availability of substitutes and the proportion of income spent on the product. Firstly, the availability of substitutes plays a crucial role in determining PED. If there are many substitutes available for a product, its demand is likely to be more elastic. This is because consumers can easily switch to another product if the price of the initial product rises. Secondly, the proportion of income spent on a product also influences its elasticity. If a product consumes a significant portion of a consumer's income, even a slight price change can have a substantial impact on their purchasing decisions, making the demand more elastic.

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