Chapter 3 · Elasticities
Price elasticity of demand
Explore elastic and inelastic demand, total revenue and the polar cases. Explain why price elasticity changes along a straight-line demand curve.
The economic idea
Elasticity measures the responsiveness of one economic variable to a change in another. It uses percentage changes, making the coefficient independent of the units in which price and quantity are measured.
Price elasticity of demand measures the responsiveness of quantity demanded to a change in the price of a good or service, ceteris paribus. PED is calculated as the percentage change in quantity demanded divided by the percentage change in price.
Price and quantity demanded normally move in opposite directions, so PED is usually negative. In IB classifications, the absolute value is commonly used: demand is elastic when the magnitude is greater than one, inelastic when it is less than one, and unit elastic when it is equal to one.
The main determinants of PED are the number and closeness of substitutes, whether the good is a necessity or luxury, the proportion of income spent, the time available to adjust and whether consumption is habitual or addictive.
Total revenue is price multiplied by quantity sold. PED determines whether the proportionate quantity response reinforces or outweighs a price change, making elasticity useful to firms considering pricing decisions and governments considering indirect taxation.
Reading elastic demand
“Quantity demanded” is measured on the horizontal axis and records the amount consumers are willing and able to buy.
“Price” is measured on the vertical axis and records the good’s own price.
“D” is the demand schedule. Moving along it changes price and quantity demanded while income, tastes, related-good prices and other demand determinants are held constant.
The measurement point: A
“A” identifies the position at which PED is being measured. The guide lines connect it to “P” on the price axis and “Q” on the quantity axis. It is an observation on “D”, not a market equilibrium.
What the current elastic case means
At the measurement point, the percentage change in quantity demanded is proportionately greater than the percentage change in price, so the absolute value of PED is greater than one.
Moving “A” along the same straight curve can change the elasticity coefficient even though the curve’s slope remains constant. Elasticity uses percentage changes and therefore depends on the price and quantity at which it is measured.
The total-revenue connection
Because demand is elastic at the measurement point, price and total revenue move in opposite directions: a price fall raises total revenue, while a price rise lowers it.
Explain the two effects on revenue: a price cut lowers the amount received per unit but increases the number of units sold along a downward-sloping demand curve. With elastic demand, the quantity response outweighs the price effect for a small change around the measurement point. For a large discrete change, use the two supplied price–quantity pairs to calculate revenue directly rather than assuming point elasticity stays constant.
Higher revenue is not automatically higher profit. Profit also depends on the costs of producing and selling the extra output. A pricing recommendation therefore needs more information than PED alone.
How to interpret a price change
Choose two price–quantity observations on the unchanged “D” curve. A change in price creates movement along demand, not a shift of demand.
Calculate the percentage change in quantity demanded and the percentage change in price using a consistent method, such as the midpoint method when comparing two observations.
Divide the percentage change in quantity demanded by the percentage change in price, then use the absolute value to classify the degree of responsiveness.
Translate the classification into consumer behaviour and the likely total-revenue effect instead of stopping at the coefficient.
Common mistakes to avoid
- A steep demand curve is not automatically inelastic and a flat curve is not automatically elastic. Slope uses absolute units; PED uses percentage changes.
- “A” is not an equilibrium point. A demand-only diagram contains no supply curve with which to determine equilibrium.
- A price change causes movement along the demand curve. A change in income, preferences or another non-price determinant would shift demand and is not used to calculate PED along one curve.
How to draw this diagram
- Title the diagram “Price elasticity of demand”. Label the horizontal axis “Quantity” and the vertical axis “Price”.
- Draw D first and label it clearly.
- Mark each relevant intersection and distinguish the initial, market and socially optimum or policy outcomes where applicable.
- Add the relevant guide lines and shade the economic area only after its boundaries are established.
- Check that every symbol used in the explanation appears on the diagram and add arrows showing the direction of change.
Assumptions and limitations
- The coefficient applies to the price range, market, population and time period from which it is estimated; it should not be treated as permanently fixed.
- Ceteris paribus is required. If income, tastes, expectations or related-good prices also change, the observed quantity response cannot be attributed solely to price.
- Point elasticity describes responsiveness at one position; arc elasticity is more appropriate for a discrete movement between two observations.
- PED helps predict revenue and quantity effects but does not by itself establish profitability, welfare or the equity of a pricing or tax decision.