PRICE ELASTICITY OF DEMAND

IBDP ECONOMICS
IB PROGRAM

SEPTEMBER 9, 2024
RUSTAM MAZITOFF
Content

• Concept of elasticity
• Price elasticity of demand (PED)
• Degrees of PED: theoretical range of values for PED
• Changing PED along a straight line downward
sloping demand curve (HL)
• Determinants of PED: number and closeness of
substitutes, degree of necessity, the proportion of
income spent on the good, time
• Relationship between PED and total revenue
• Importance of PED for business and government
decision making
• PED of primary goods and manufactured goods
Elasticity

• Elasticity is an economic concept based on change. It measures how

consumers and producers respond to changes in variables that affect
demand and supply.
• Elasticity is important because it allows us to analyse what happens to
demand and supply in markets when change takes place and to evaluate
the consequences of change. For example, when the price of electricity
rises we can use elasticity to analyse how consumers and producers will
respond to the rise in price.
Elasticity

• Price elasticity of demand is the responsiveness of quantity demanded for

a good to a change in its price. It is measured by the equation:
• % change in Qd / % change in P
• For example, if the price of film and TV streaming services such as Netflix
increases from $20 per month to $24 (20 per cent increase) and quantity
demanded falls from 10 million subscribers to 7.5 million subscribers (25
per cent decrease). This is shown in diagram and is calculated as:
-25% QD / +20% P = -1.25 or 1.25 (PED)
Elasticity

• The value of PED is normally negative because of the law of demand. The
negative value is often ignored because the PED value is nearly always
negative. In future calculations, the PED will be expressed as a positive
value.
• Price elastic demand
• If the PED value is greater than 1 then the good’s demand is price elastic.
This means a change in price leads to a proportionately greater change in
quantity demanded. In the film and TV streaming service example, the
value is 1.25 which means for every 1% increase in price, the quantity
demanded decreases by 1.25%. This is a price elastic relationship
because the proportionate change in quantity demanded is greater than
the proportionate change in price.
• Theoretically, the demand curve can be perfectly horizontal or perfectly
elastic. This gives a PED of infinity. This is applicable in the theoretical
market form of perfect competition.
Elasticity

• Unitary elasticity of demand

• If the PED value is 1 then PED is unitary. This means that for every 1 per
cent change in price quantity demanded changes by 1%. It is unlikely a
good will have a PED of 1 but the value could be close to 1. This is shown
by a demand curve which is a rectangular hyperbola.
Elasticity

• Price inelastic demand

• If the demand for a good has a PED value of less than 1 then it is price
inelastic meaning that a change in the price of a good leads to a less than
proportionate change in quantity demanded. If the price of rice rises from
$0.50 to $0.55 and the quantity demanded falls from 4m units to 3.8m then the
PED of rice is calculated as: -5% QD / +10% P = 0.5 (PED)
• The PED value of 0.5 means for every 1% change in the price of rice, the
quantity demanded changes by 0.5%. In theory, a perfectly vertical demand
curve represents perfectly inelastic demand. This gives a PED of 0.
Inquiry case example - Price elasticity
and ticket pricing

• The American NFL team, The Los Angeles Rams have written to their season
ticket holders to announce they are raising ticket prices by 8% next season.
The team’s owners are confident they can achieve this price increase following
the team’s on-field success as winners of the Super Bowl. The Rams are led
by wide receiver Cooper Kupp, named the Most Valuable Player 2022.
• It is interesting to analyse the PED of the demand for Los Angeles Rams
season tickets. The average price of the ticket is $118 so an 8% price increase
is going to add over $9 to the selling price of a ticket. The team’s home games
often sell out and the number of tickets sold is not expected to fall significantly.
This may imply that the demand for the Rams tickets is price inelastic because
the people who buy the team's season tickets are very brand loyal to the
Rams.
Inquiry case example - Price elasticity
and ticket pricing

• a. Outline what you understand by price inelastic demand. [2]

• b. The Los Angeles Rams have increased their average ticket price (which was
$118) by 8% and this has caused the quantity demanded for tickets to fall by
2%. The quantity demanded before the change in price was 70,000.
• (i) Calculate the new selling price for the tickets. [2]
• (ii) Calculate the new quantity demand for the tickets. [2]
• (iii) Calculate the PED of Los Angeles Rams tickets. [2]
• c. Outline what price inelastic demand for Los Angeles Rams tickets means.
[2]
Elasticity Along the Demand Curve

• As the price of a good decreases along the demand curve, the PED value falls.
Diagram 2.19 illustrates the demand curve for training shoes. As the price of the
shoes falls from $50 to $45 the quantity demand increases from 2m units to 3m
units. This is a PED of: +50% QD/ -10% P = 5 (price elastic) On the upper section
of the demand curve, PED is price elastic. When the price of the training shoes is
reduced from $20 to $15 the quantity demanded rises by 8m to 9m units. This is a
PED of: +12.5% QD / -25% P = 0.5 (price inelastic)
Elasticity Along the Demand Curve

• PED falls as you move down the demand curve because a change in price at a
relatively high price level has a greater proportionate effect on quantity demanded
than the effect of a change in price at a relatively low price. On the upper section
of the demand curve in diagram 2.19, PED is price elastic because of the way
percentages are calculated. A $5 price reduction from a price of $50 is a smaller
percentage change than a $5 price reduction from a $20 price.
• Similarly, a 1m quantity increase from 2m to 3m is a larger percentage increase
than a 1m increase from 8m to 9m. When the PED is calculated it will have a
greater value at higher prices on the demand curve and a smaller value at lower
prices.
Determinants of Price Elasticity of Demand

• Number and closeness of substitutes

• The greater the number of close substitutes a product has the more price elastic its
demand tends to be because consumers can easily swap between alternatives
when the price of the good changes.
• This relates to the way you define the market for a good: the more precisely
defined the market for a good, the more close substitutes it tends to have. There
are many different brands of biscuits on the shelves of a supermarket, so any one
brand of biscuit tends to be relatively price elastic. A rise in the price of Oreo
biscuits, for example, may well lead to consumers switching to alternative brands
such as Jaffa Cakes. If the market definition broadened from brands of biscuits to
biscuits as a product, then there would be fewer close substitutes (chocolate bars,
crisps, cakes, etc.) and the demand for biscuits would be more inelastic.
Determinants of Price Elasticity of Demand

• Luxury or necessity
• The demand for goods that are a necessity for a consumer tends to be more price inelastic
than the demand for luxury products which tend to be more price elastic. This is because
consumers need to keep buying necessity goods when their price increases. For example, if
the price of electricity rises, quantity demand will fall by a proportionately smaller amount
because people still need to use electricity to light their homes and run their appliances.
Consumers do not, on the other hand, need to keep consuming luxury products if their price
increases. For example, if the price of long-haul air tickets increases, people can take fewer
holiday flights and the quantity demanded would fall by a relatively greater amount.
• Proportion of income
• The demand for goods that account for a smaller proportion of household income tends to be
more price inelastic. This is because any change in price will have a relatively small impact
on household income. For example, consumers might spend a relatively small amount of
their income on chewing gum each month, whereas they might spend a larger proportion of
their income on train travel. A 20 per cent increase in the price of $1 a pack of chewing gum is
likely to have a smaller impact on consumer income than a 20 per cent increase in the price
of a $15 daily train ticket, so the PED of chewing gum tends to be more inelastic than the
train tickets.
Determinants of Price Elasticity of Demand

• Type of consumer
• High-income consumers tend to be less responsive to price changes for goods
than people on lower incomes. This is because any price change will have a
smaller real income effect on high-income consumers compared to low-income
consumers. For example, if the price of a prestige watch rises from $2000 to
$2500 then it may have little impact on a wealthy buyer who has an income of
a million US$ per year. This is why the demand for luxury goods sold to
wealthy individuals tends to be relatively price inelastic. The demand for high-
end fashion labels such as Prada and Armani has relatively inelastic demand
for their goods because they are targeted at wealthy consumers.
Determinants of Price Elasticity of Demand

• Time
• Over time PED tends to become more price elastic because consumers can
alter their consumption patterns in response to a price change. In the short run
an increase in the price of petrol, for example, will lead to a relatively small
decrease in the quantity demanded because petrol buyers can cut back on
some leisure journeys, but they still have to get to work and take their children
to school.
• In the long run, buyers could change to a more fuel-efficient car and move to a
house nearer to where they work. Thus the demand for petrol becomes more
price elastic in the long run.
• Diagram shows how the PED for petrol increases from: -25% QD / +20% P =
1.25 PED to -60% QD/ +20% P = 3 PED
Price Elasticity of Demand and Revenue

• Revenue is the value of income a business receives from selling a good. It is

calculated by: price x quantity = total revenue
• For example, if an airline sells 500,000 seats a year at a price of $200 then the
total revenue is: 500,000 x $200 = $100,000,000
• Firms can use an understanding of PED to increase their total revenue. When
the demand for a good is price elastic, total revenue rises when the price is
reduced and decreases when the price is increased. When the demand for a
good is inelastic, total revenue rises when the price is increased and
decreases when the price is reduced.
Price Elasticity of Demand and Revenue

• An airline sells seats to a holiday destination. Ticket A is sold during the school
summer holidays when demand is relatively price inelastic because families
need to travel at that time and the seats are considered a relative necessity.
Ticket B is sold outside school holiday time when demand is relatively price
elastic because people do not have to travel at that time and seats are
considered more of a luxury.
• The table shows the price, quantity and revenue for tickets A and B before and
after a 20 per cent increase in the price of seat tickets from time period year 1
to time period year 2. The total revenue for ticket A, which has price inelastic
demand, increases by $128,000 and the total revenue for ticket B, which has
price elastic demand, decreases by $84,000.
Price Elasticity of Demand and Revenue

• Diagram shows how an increase in price for seat ticket A leads to a rise in total
revenue. Area EFBG shows the total revenue after the price increase which is
greater than area ABCD, which is the total revenue before the price increase.
Price Elasticity of Demand and Revenue

• Diagram shows how an increase in seat ticket B leads to a fall in total revenue.
Area ABCD shows the total revenue before the price increase, which is greater
than area EFBG which represents the total revenue after the price increase.
Price Elasticity of Demand and Revenue

• The impact on total revenue of changes in PED along the demand curve
• It is important to remember that PED changes as you move along the demand curve and this
will affect the revenue from a price change. In diagram we can see that a rise in the price of
the airline seat ticket with inelastic demand will lead to an increase in total revenue, but as
PED rises the rate of increase of total revenue will slow down and peak when PED is unitary.
Any increase in price as we move onto the elastic section of the demand curve will lead to a
fall in revenue. The same thing happens if the price is reduced on the elastic section of the
demand curve. Revenue rises and peaks when PED is unitary and then falls when PED is
inelastic.
Government decision-making and price
elasticity of demand

• PED will be useful to governments when they are making policy decisions that
affect the price of goods and services. PED will have an effect on tax, subsidy,
maximum price and minimum price decisions made by governments.
• The price elasticity demand of commodities compared to manufactured
goods
• Economists are often concerned with the differences in PED between commodities
and manufactured goods. The demand for agricultural goods tends to be relatively
inelastic because they are often necessities and have fewer close substitutes
compared to manufactured goods. If the price of a commodity such as rice
increases then households reduce the quantity demanded by a proportionately
smaller amount than the increase in price. This is because households depend on
rice as part of their diet and there are relatively few close substitutes for it.
• Manufactured goods such as personal computers (PCs) are often relative luxuries
so the demand for them tends to be more price elastic. The demand for
manufactured goods is also considered price elastic because of the number of
substitutes they have. If the price of a PC rises people could buy a substitute for a
PC like a new mobile phone or tablet computer.
Government decision-making and price
elasticity of demand

• Evaluating price elasticity of demand

• PED is used extensively by businesses looking to increase revenue and profit from
their pricing strategies. There are, however, some limitations to PED:
• It can change over time as consumer behaviour changes. A new
competitor might enter the market for a good which makes the PED for a
good more elastic.
• PED is based on the ceteris paribus assumption that price is the only
variable that is changing. Income and the price of related goods, as well
as other factors that affect demand, are all changing at the same time as
the price of the good.
• When a firm changes price there is always going to be uncertainty about
how consumers will react. If the price of a good rises above its anchor
point then the quantity demanded might fall more than expected.
Inquiry case example - The price elasticity
of demand for oil

• 13 countries are members of the Organisation of the Petroleum Exporting Countries

(OPEC). This is an organisation formed in 1960 to regulate the supply of oil to maintain
price stability in its market. Member countries include Algeria, Iran, Nigeria, Saudi
Arabia and Venezuela. In July last year, OPEC decided to cut the supply of oil by 9.7
barrels per day to force the oil price higher.
• By the end of December, the price of a barrel of oil had increased to just over $50 from
a low of $20 in April. Throughout 2021 and 2022 the price of oil has continued to rise
because of the global economic recovery from the pandemic and geopolitical factors
related to the conflict in Ukraine. Oil is currently trading at around $80 a barrel which
has significantly increased the revenues of OPEC countries.
• a. Explain two reasons why the price elasticity of demand for commodities tends to be
price inelastic. [10]
• b. Using a real-world example, evaluate the usefulness of price elasticity of demand for
producers trying to increase their revenues by raising prices. [15]
Inquiry case example - The price elasticity
of demand for oil

• a. Explain two reasons why the price elasticity of demand for commodities tends to be
price inelastic. [10]
• Definitions of PED, price inelastic demand and commodities.
• Diagram to show price inelastic demand for oil.
• The demand for commodities tends to be inelastic because they are often necessity
goods.
• The demand for commodities tends to be inelastic because they have relatively few
substitutes.
Inquiry case example - The price elasticity
of demand for oil

• b. Using a real-world example, evaluate the usefulness of price elasticity of demand for producers
trying to increase their revenues by raising prices. [15]
• Definitions of PED and revenues.
• A diagram to show an increase in revenues as the price of oil rises.
• If producers increase the price of oil this will lead to an increase in revenue because the demand
for oil is price inelastic. As the price of oil increases in the diagram the revenue producers receive
from selling oil increases from area ABCD to area BGEF.
• An example of OPEC increasing the price of oil by cutting its supply to increase revenue.
• Evaluation/synthesis might include the problem of accurately measuring the PED of oil which
makes forecasting the change in revenue difficult to predict. In addition, changes in non-price
factors such as income might be affecting demand and oil revenues. PED also tends to become
more elastic in the long run which will have an impact on revenues.