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Edexcel Economics (B) A level - 2.2.1 Price Elasticity of Demand
Elasticity: how much one variable changes in response to a change in another related variable.
Price elasticity of demand (PED) is important for businesses in determining their pricing strategy and which business objectives to focus on.
PED measures the responsiveness of quantity demanded in response to a change in price.
PED = %CHANGE IN QUANTITY DEMANDED/%CHANGE IN PRICE
When demand is very responsive, it is price elastic
Price elastic demand>1
A small increase in price causes a larger decrease in quantity
QD changes at a higher percentage than price
Price inelastic demand<1
A large increase in price causes a small decrease in QD
QD changes by less than the percentage change in P
Price changes have little impact on quantity bought
FACTORS INFLUENCING PED
1. Availability and closeness of substitutes
Goods with lots of substitutes usually have price elastic demand. E.g Apple and Samsung
However, if the good is unique (through product differentiation) and has fewer alternatives, then demand is inelastic.
If consumers can't easily switch to a cheaper good then they may choose to limit consumption
2. Necessity
If a good is needed for survival e.g food or we feel we can't do without it, our purchases may not be influenced by price hence making demand relatively price inelastic.
However, if it is a luxury good then demand will be more elastic as it is not vital and consumers can forgo the good.
3. Time Period
People take time to adjust to price changes so for example, if the price of energy increases consumers may take a while before they switch to a cheaper supplier. It may take time for people to collect information about alternatives or they may be tied by contracts so can't change immediately.
Hence, demand is inelastic in the SHORT TERM but elastic in the LONG TERM (this could be used as a potential evaluation point for PED)
4. Proportion of spending
Expensive items that take up more of a consumer's income tend to have a higher price elasticity.
Goods and services that take up a smaller proportion of total spending will be more inelastic than those which take up a larger proportion.
5. Habitual consumption
If people are used to buying a good, they are unlikely to change consumption if the price changes thus demand tends to be price inelastic.
The market that a product is in can also affect PED
In a mass market:
Products are subject to extreme price competition and so the availability of many substitutes means that goods in this market are price elastic.
In a niche market:
Consumers look for specialised products that meet their specific needs so demand is price inelastic.
RELATIONSHIP BETWEEN PED AND TOTAL REVENUE
Firms have a stronger position and market power if the demand for their product is price inelastic. This is why many strive to differentiate and build strong brand images.
TOTAL REVENUE = PRICE x QUANTITY SOLD
When demand is price elastic, a small decrease in price causes demand to increase significantly hence TR increases.
BUT when demand is price inelastic, a reduction in price causes demand to only increase by a small amount so TR actually falls.
If price elastic:
Increasing price, decreases TR
Decreasing price, increases TR
If price inelastic:
Increasing price, increases TR
Decreasing price, decreases TR
To fully understand this concept, try drawing a diagram when demand is elastic/inelastic and seeing what effect a reduction/increase in price has on QD and thus TR.
Useful links
https://www.tutor2u.net/business/reference/price-elasticity-of-demand
https://www.tutor2u.net/economics/reference/price-elasticity-of-demand
https://www.youtube.com/watch?v=6qH0N1Ircfc
https://www.youtube.com/watch?v=HHcblIxiAAk
https://www.youtube.com/watch?v=P5INeFrIBT4
https://www.youtube.com/watch?v=JMtXiYGJDrk