Price elasticity of demand (PED)

The formula is:

PED = \frac{% \text{ change in quantity demanded}}{% \text{ change in price}}

Where:

• % \text{ change in quantity demanded} = \frac{Q_2 - Q_1}{Q_1} \times 100
• % \text{ change in price} = \frac{P_2 - P_1}{P_1} \times 100

Q_1 is the initial quantity, Q_2 is the new quantity. P_1 is the initial price, P_2 is the new price.

Key Point: PED is always a negative number because price and quantity demanded move in opposite directions (law of demand). However, Cambridge examiners typically accept the absolute value (ignoring the negative sign) unless specified otherwise. Always check the question context.

Demand is more likely to be elastic (responsive) if:

1. Substitutes: There are many close substitutes available (e.g., different brands of cereal). If the price rises, consumers switch easily.
2. Necessity vs. Luxury: Necessities (e.g., insulin, bread) tend to be inelastic. Luxuries (e.g., designer handbags) tend to be elastic.
3. Proportion of Income: Goods that take up a large portion of income (e.g., cars, holidays) are more elastic. Cheap items (e.g., salt, matches) are inelastic because price changes don't matter much to the budget.
4. Time Period: Demand becomes more elastic over time. In the short run, consumers may be stuck with habits or contracts. Over time, they find alternatives.
5. Brand Loyalty: Strong brand loyalty makes demand more inelastic.
6. Addictive Goods: Goods like cigarettes or coffee are often inelastic because consumers continue buying despite price rises.

Total Revenue (TR) = Price (P) \times Quantity Sold (Q).

The relationship between price changes and total revenue depends on PED:

1. Inelastic Demand (|PED| < 1):

   • If Price rises, Total Revenue rises.
   • Reason: The % drop in quantity is smaller than the % rise in price. The gain from higher price outweighs the loss from fewer sales.
   • If Price falls, Total Revenue falls.

2. Elastic Demand (|PED| > 1):

   • If Price rises, Total Revenue falls.
   • Reason: The % drop in quantity is larger than the % rise in price. The loss from fewer sales outweighs the gain from higher price.
   • If Price falls, Total Revenue rises.

3. Unitary Elastic Demand (|PED| = 1):

   • Price changes have no effect on Total Revenue. The % change in price is exactly offset by the % change in quantity.

1. Producers/Firms:

• Pricing Strategy: If demand is elastic, firms may lower prices to increase total revenue and market share. If inelastic, they may raise prices to increase revenue.
• Product Differentiation: Firms try to make demand inelastic through branding, advertising, and quality improvements to gain pricing power.

2. Government:

• Taxation: Governments tax goods with inelastic demand (e.g., cigarettes, alcohol, fuel) because these taxes raise significant revenue without causing a large drop in consumption (and thus less deadweight loss).
• Subsidies: Governments may subsidize goods with elastic demand or necessities to ensure affordability.

3. Consumers:

• Budgeting: Consumers spend a larger proportion of their income on goods with inelastic demand (like rent or utilities) regardless of price changes, which can lead to financial stress if prices rise.

4. Workers (Labor Market):

• Wage Bargaining: The elasticity of demand for labor affects unions' power. If the demand for a specific type of labor is inelastic (e.g., specialized surgeons), unions have more power to negotiate higher wages without causing significant job losses. If demand is elastic, wage increases may lead to large reductions in employment.