Price Elasticity of Demand (PED) | O Level Economics 2281 & IGCSE Economics 0455 | Detailed Free Notes To Score An A Star (A*)

2.7.1 Definition of PED

• Price Elasticity of Demand (PED) measures the responsiveness of quantity demanded of a product to a change in its price.
• Formula basis: % change in quantity demanded / % change in price
• It is always negative, but often expressed in absolute value for simplicity.

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2.7.2 Calculation of PED

• PED formula:
  PED = (% change in quantity demanded) / (% change in price)
• Percentage change formula:
  % change = (New value – Original value) / Original value × 100
• Interpretation of PED values:
  • PED > 1: Demand is price elastic (responsive to price changes).
  • PED < 1: Demand is price inelastic (less responsive to price changes).
  • PED = 1: Unitary elasticity (proportionate response).
  • PED = 0: Perfectly inelastic (no change in demand).
  • PED = ∞: Perfectly elastic (any price rise causes demand to fall to zero).

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2.7.3 Determinants of PED

• Availability of Substitutes: More substitutes → more elastic.
• Nature of the Good:
  • Necessities: Inelastic demand (e.g., salt, rice).
  • Luxuries: Elastic demand (e.g., watches, chocolates).
• Proportion of Income Spent on the Good: Expensive items (cars) are more elastic.
• Time Period: Demand becomes more elastic over time as consumers adjust.
• Habit Forming Goods: Tend to be inelastic (e.g., cigarettes).
• Definition of the Market:
  • Broad category (food) → inelastic.
  • Narrow category (ice cream) → elastic.

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2.7.4 PED and Total Spending on a Product / Revenue

• Total revenue (TR) = Price × Quantity demanded.
• Effect of PED on TR:
  • If demand is elastic (PED > 1):
    • A price fall → increase in total revenue.
    • A price rise → decrease in total revenue.
  • If demand is inelastic (PED < 1):
    • A price fall → decrease in total revenue.
    • A price rise → increase in total revenue.
  • If PED = 1, revenue remains unchanged.
• Graphical Analysis:
  • On a steep demand curve (inelastic), price changes have little effect on quantity.
  • On a flat demand curve (elastic), price changes have a significant effect on quantity.

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2.7.5 Significance of PED

For Producers:

• Helps set pricing strategies:
  • For inelastic goods, raise prices to increase revenue.
  • For elastic goods, lowering prices may increase total revenue.
• Crucial for forecasting sales and revenue changes.
• Affects marketing strategies: Elastic products may benefit more from promotions and price cuts.

For Consumers:

• Indicates how easily they can substitute between products.
• Helps in making budgeting decisions.

For Government:

• Helps assess impact of indirect taxes (e.g., on petrol, cigarettes):
  • Inelastic goods → tax increases bring more revenue with less reduction in quantity.
• Assists in policy formulation (e.g., subsidies, price controls).

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Diagrammatic Analysis of PED

• Elastic Demand Curve:
  • Flatter slope.
  • Small change in price → large change in quantity.
• Inelastic Demand Curve:
  • Steep slope.
  • Large change in price → small change in quantity.
• Unitary Elasticity Curve:
  • Revenue remains unchanged as price changes.

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Real-Life Examples

Product	Likely PED	Reason
Salt	<1	Necessity, no close substitutes
Pepsi	>1	Many substitutes (e.g., Coca-Cola)
Electricity (short term)	<1	Hard to substitute, necessity
Designer Handbags	>1	Luxury item, large portion of income
Public Transport	>1	Many alternatives in long run

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Case Study Example

• A firm sells 100 units at $10. If it increases price to $12 and sales fall to 80 units:
  • % change in quantity = (-20/100) × 100 = -20%
  • % change in price = (2/10) × 100 = 20%
  • PED = -20% / 20% = -1 → Unitary Elastic Demand

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Implications of PED in Business Decision-Making

• PED helps:
  • Decide whether to increase or decrease prices.
  • Evaluate effect of promotions and advertising.
  • Estimate impact of external shocks like taxation or inflation.
  • Assess competitiveness in different markets.
  • Plan supply chain and inventory adjustments.

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Key Exam Tips

• Always use absolute values when comparing PED.
• Mention direction of change when interpreting PED values.
• Understand PED is not constant along a demand curve.
• Use calculation AND diagram when explaining impact on revenue.
• Link PED to real-world context like taxation, consumer behavior, or market planning.