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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

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