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

The concept of price elasticity of demand

• Price elasticity of demand (PED) measures how responsive demand for a product is to a change in price

  • In general,

    • when the price for a product increases, demand falls

    • when the price for a product decreases, demand rises

  • PED answers the question: By how much will demand change?

Calculating price elasticity of demand

• 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

• PED can be calculated using the formula

• To calculate a % change, use the formula

• In some cases, you may be required to calculate the percentage change in price or demand

• This involves rearranging the PED formula

Interpreting price elasticity of demand

1. 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; 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

2. 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 an decrease in revenue

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

    • Also addictive products such as cigarettes and sugary foods

The impact of price elasticity of demand on pricing decisions

• If businesses can determine the price elasticity of demand for their products, they can adjust pricing strategy to maximise revenue

• If demand for their products is relatively price inelastic (between 0 and -1), raising the price will lead to an increase in total revenue

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

  • Price skimming strategies are best employed for products that are price inelastic in demand

• If demand for their products is relatively price elastic (PED > -1), raising the price will lead to a fall in total revenue

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

  • Competitive pricing strategies are best employed for products that are price elastic in demand

Price elasticity of demand and total revenue

Price elastic demand

• PED is greater than 1

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

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

Price inelastic demand

• PED is between 0 and 1

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

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

Limitations of price elasticity of demand

• Price elasticity of demand (PED) can help businesses decide how much to charge for their products by showing how sensitive customers are to price changes

• However, relying too much on PED when making decisions can lead to problems, especially if the data is wrong or if other important factors are ignored

• Difficult to measure accurately

  • PED calculations need reliable data on how demand changes with price, which can be hard to collect

    • E.g. A business may not know exactly how much demand will fall if it raises prices by 10%

• Assumes other factors stay the same

  • PED only looks at price and demand, but things like income, trends or marketing also affect sales

    • E.g. A fashion brand may raise prices expecting little change in demand, but a trend shift makes the item less popular

• Not useful for new products

  • Without past data, it’s hard to estimate PED for products that haven’t been sold before

    • E.g. A tech company launching a new gadget can’t predict how price changes will affect demand

• Ignores competitor actions

  • PED doesn’t consider how rival businesses might respond to a price change

    • E.g. A supermarket lowers prices to boost sales, but rivals do the same, so demand stays unchanged

• Customer behaviour can change

  • PED is not fixed – it can change as customer preferences or incomes change

    • E.g. Petrol demand may become more elastic as electric cars become more common

• Limited use beyond pricing

  • PED mainly helps with pricing decisions, not choices like product design, location or hiring

  • However, it can give clues about brand strength or customer loyalty, which may influence other areas

• Short versus long-term effects

  • Demand might be inelastic in the short term but more elastic in the long term as customers adjust

  • E.g. A mobile network raises prices and sees little change at first, but over time people switch providers