Price Elasticity of Demand (AQA A Level Business): Revision Note

The importance of price elasticity of demand

• Price elasticity of demand (PED) measures how responsive the quantity demanded of a product is to a change in its price

• In general:

  • When the price rises, demand falls

  • When the price falls, demand rises

  • PED answers the question: by how much?

• Understanding PED helps businesses predict the effect of a price change on sales volume and revenue, making it a valuable tool for pricing decisions

Calculating and interpreting PED

• PED will always be a negative value due to the inverse relationship between price and quantity

  • If the price goes up, the quantity demanded goes down

  • If the price goes down, the quantity demanded goes up

Formula

$\text{PED = }\frac{\%\mathrm{Change}\mathrm{in}\mathrm{quantity}\mathrm{demanded}}{\%\mathrm{Change}\mathrm{in}\mathrm{price}}$ 

• The numerical value of PED indicates the responsiveness of demand to a change in price

Price elastic demand

• PED value lower than -1 (e.g -1.2)

• Demand is more responsive to a change in price

  • For every 1% change in price, demand will change by more than 1%

• An increase in price will lead to a fall in revenue, whilst a decrease in price will lead to an increase in revenue

  • Examples include luxury products such as cars, smartwatches, foreign holidays, cinema visits, jewellery and branded goods

Price inelastic demand

• PED value is between 0 and -1 (e.g., -0.7)

• Demand is less responsive to a change in price

  • For every 1% change in price, demand will change by less than 1%

• An increase in price will lead to an increase in revenue; a decrease in price will lead to a decrease in revenue

  • Examples include necessities such as bread, milk, eggs and potatoes, fuel, rent and toothpaste

    • Also addictive products such as cigarettes and sugary foods

Factors influencing the PED

Brand loyalty

• The aim of advertising and marketing expenditure by a business is to shift the demand curve to the right and make the demand more price inelastic

  • For example, Coke consumers are more brand loyal to Coca-Cola and refuse to buy Pepsi, even though their taste is very similar

Availability of substitutes

• PED will be more price inelastic for goods that have fewer substitutes

  • For example, petrol has fewer substitutes and is more price inelastic, whereas chocolate bars have more substitutes and are more price elastic

The proportion of income taken up by the product

• The smaller the proportion of income we spend on a product, the more price inelastic the demand will be

  • For example, a small amount of income is spent on salt, so the demand for salt is more price inelastic. However, buying a new car takes up a bigger proportion of consumer income, so the PED is higher

Luxury or necessity

• Necessities are required as part of consumers' daily needs, and therefore, demand for them is more price inelastic

  • For example, bread, milk, petrol, gas and electricity might be considered necessities

• Luxuries are not essential, and therefore, demand for them is more price elastic

  • For example, smoked salmon, Nike Air Jordans and foreign holidays might be considered luxuries

  • However, a strong brand reputation will likely make even luxuries less price elastic

Time

• The longer the time period under consideration, the more price elastic the demand for a good or service is likely to be (consumers have more time to search for substitutes)

• The shorter the time period under consideration, the more price inelastic the demand for a good or service is likely to be

  • For example, if the price of petrol increases, making driving more expensive, there is little that consumers can do in the short term

  • However, they may switch to alternatives such as public transport or bicycles in the long term

Price elasticity of demand and revenue

• If businesses can determine the PED for their products, they can adjust their pricing strategy to maximise their revenue

Price elastic demand

• If demand for a product is price elastic, raising the price will lead to a fall in total revenue

• However, lowering the price will lead to a rise in total revenue

• PED is less than -1

• An increase in the selling price reduces the total amount of revenue generated from sales

• A reduction in the selling price increases the total amount of revenue generated from sales

Price inelastic demand

• If demand for their products is price inelastic, raising the price will lead to an increase in total revenue

• However, lowering the price will lead to a fall in total revenue

• PED is between 0 and -1

• An increase in the selling price increases the total amount of revenue generated from sales

• A reduction in the selling price reduces the total amount of revenue generated from sales