IB Economics - Price Elasticity of Demand

This study note for IB Economics covers Price Elasticity of Demand

Understanding Price Elasticity of Demand (PED)

Price Elasticity of Demand (PED) measures the responsiveness of the quantity demanded of a good to a change in its price. This concept helps in understanding how price changes influence consumer purchasing behavior along a given demand curve.

Key Concepts

• Responsiveness: Indicates how much the quantity demanded changes when the price changes.
• Demand Curve: A graphical representation showing the relationship between the price of a good and the quantity demanded.

Formula for PED

PED = Percentage Change in Quantity Demanded / Percentage Change in Price

Mathematical Value

• The PED value is typically negative due to the inverse relationship between price and quantity demanded (law of demand). However, it is often treated as positive by taking the absolute value.

Types of Price Elasticity of Demand

1. Price Elastic Demand

• Definition: When the percentage change in quantity demanded is greater than the percentage change in price.
• PED Value: Greater than 1.
• Diagram:
• Example: Luxury cars, designer clothes.

2. Price Inelastic Demand

• Definition: When the percentage change in quantity demanded is less than the percentage change in price.
• PED Value: Less than 1.
• Diagram:
• Example: Essential medications, basic food items.

3. Unit Elastic Demand

• Definition: When the percentage change in quantity demanded is equal to the percentage change in price.
• PED Value: Equal to 1.
• Diagram:
• Example: Theoretical midpoint of a demand curve.

4. Perfectly Elastic Demand

• Definition: When consumers will only buy at one price and no quantity is demanded at any other price.
• PED Value: Infinity.
• Diagram:
• Example: Commodities in perfectly competitive markets (e.g., identical agricultural products).

5. Perfectly Inelastic Demand

• Definition: When the quantity demanded remains constant regardless of price changes.
• PED Value: Zero.
• Diagram:
• Example: Life-saving drugs (e.g., insulin).

Determinants of PED

• Number and Closeness of Substitutes: More substitutes lead to higher elasticity.
• Degree of Necessity: Necessities tend to be inelastic.
• Time Period: Demand is more elastic over the long run as consumers adjust their behavior.
• Proportion of Income: Goods that take up a larger proportion of income tend to have more elastic demand.

Calculating PED

• Example Calculation:
  • Initial Price (P1) = $10, Final Price (P2) = $12
  • Initial Quantity Demanded (Q1) = 100 units, Final Quantity Demanded (Q2) = 80 units
  • Percentage Change in Quantity Demanded=(Q2−Q1)Q1×100=(80−100)100×100=−20%
  • Percentage Change in Price=(P2−P1)P1×100=(12−10)10×100=20%
  • PED = −20%/20% = −1
  • Absolute value of PED = 1 (Unit Elastic Demand).

Variability of PED Along a Demand Curve

• PED varies along a straight-line demand curve because the percentage changes in price and quantity are not constant. At higher prices, demand is more elastic, while at lower prices, it is more inelastic.

Topical Real-World Examples

• USA: The demand for gasoline tends to be price inelastic due to its necessity for commuting.
• Brazil: Demand for coffee is more elastic due to the availability of substitutes like tea.

Related Topics

• Cross Elasticity of Demand: Measures responsiveness of demand for one good to changes in the price of another good.
• Income Elasticity of Demand: Measures responsiveness of demand to changes in income.
• Supply Elasticity: Measures responsiveness of quantity supplied to changes in price.

Worked Examples

1. Example 1:
   • Initial Price: $20, Final Price: $25
   • Initial Quantity Demanded: 150 units, Final Quantity Demanded: 120 units
   • Calculation:
     • Percentage Change in Quantity Demanded=(120−150)150×100=−20%
     • Percentage Change in Price=(25−20)20×100=25%
     • PED=−20%25%=−0.8PED=25%−20%​=−0.8
     • Absolute value of PED = 0.8 (Price Inelastic Demand).
2. Example 2:
   • Initial Price: $50, Final Price: $40
   • Initial Quantity Demanded: 200 units, Final Quantity Demanded: 220 units
   • Calculation:
     • Percentage Change in Quantity Demanded=(220−200)200×100=10%
     • Percentage Change in Price=(40−50)50×100=−20%
     • PED=10%−20%=−0.5PED=−20%10%​=−0.5
     • Absolute value of PED = 0.5 (Price Inelastic Demand).

IB Economics Essay-Style Questions

1. Explain the concept of price elasticity of demand and its importance for businesses and governments.
2. Discuss the factors that determine the price elasticity of demand for a product.
3. Using diagrams, explain the difference between price elastic and price inelastic demand.
4. Evaluate the significance of price elasticity of demand in making pricing decisions.
5. How does the price elasticity of demand affect a firm’s total revenue?

Model Answer to Essay Question 1:

Explain the concept of price elasticity of demand and its importance for businesses and governments.

Price elasticity of demand (PED) measures the responsiveness of the quantity demanded of a good to changes in its price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. While the mathematical value of PED is usually negative due to the inverse relationship between price and quantity demanded, it is often expressed as a positive number for simplicity.

PED is crucial for businesses as it influences pricing strategies. For example, if a product has inelastic demand (PED < 1), increasing prices can lead to higher total revenue since the percentage drop in quantity demanded is smaller than the percentage rise in price. Conversely, for products with elastic demand (PED > 1), price increases might lead to a significant drop in quantity demanded, reducing total revenue. Understanding PED helps businesses optimize pricing to maximize revenue and market share.

Governments use PED to predict the impact of taxation and subsidies. For goods with inelastic demand, such as tobacco, taxes can reduce consumption and increase government revenue without significantly decreasing demand. Subsidies on essential goods with inelastic demand can make them more affordable without drastically affecting government budgets.

In conclusion, PED is a vital tool for both businesses and governments to make informed decisions that balance financial objectives with market and societal outcomes.

Multiple Choice Questions

1. What does a PED value greater than 1 indicate?
   • a) Inelastic demand
   • b) Unit elastic demand
   • c) Elastic demand
   • d) Perfectly inelastic demand
   • Answer: c) Elastic demand
2. Which of the following goods is most likely to have a perfectly inelastic demand?
   • a) Luxury cars
   • b) Life-saving medications
   • c) Designer clothes
   • d) Coffee
   • Answer: b) Life-saving medications
3. If the price of a product decreases from $10 to $8 and the quantity demanded increases from 200 to 250 units, what is the PED?
   • a) 0.5
   • b) 1.25
   • c) 2.5
   • d) 0.8
   • Answer: b) 1.25
4. Which factor is least likely to affect the PED of a product?
   • a) Availability of substitutes
   • b) Degree of necessity
   • c) Time period considered
   • d) Government regulations
   • Answer: d) Government regulations
5. At which point along a straight-line demand curve is the demand unit elastic?
   • a) At the midpoint
   • b) At the upper end
   • c) At the lower end
   • d) At any point
   • Answer: a) At the midpoint