Normal laws of demand suggest that as prices increase demand decreases whilst firms attempt to supply more (with the opposite happening as prices decrease). The concept of elasticities asks the question ‘by how much does demand and supply change?’ Recent examination reports have made it clear that “price elasticity is an important topic and students should be prepared to apply it to the examination context as well as quote the formulas.” There is a lot to learn in this section – start with a good understanding of what elasticity it and how it is measured. Then consider why it matters for businesses to have a working knowledge / estimate of the coefficient of price elasticity of demand.

1. How Markets Work – Price
Elasticity of Demand (PED)

2. How Markets Work
Price Elasticity of
Demand

3. What is Price Elasticity of Demand?
• Price elasticity of demand (PED) measures the responsiveness of
demand after a change in the good’s own price
• The basic formula for calculating the co-efficient of price
elasticity of demand is:
– Percentage change in quantity demanded divided by the
percentage change in price
• All normal goods with downward sloping demand curves will
have a negative price elasticity of demand
• Since changes in price and quantity usually move in opposite
directions, usually we do not bother to put in the minus sign
• We are more concerned with the co-efficient of elasticity
Elasticity - responsiveness of X to a change in another variable

4. Price Elasticity of Demand in Action
WH Smith have recently reduced
the price of its Kobo Mini E-
reader from £60 to £40. They
predict that sales of the E-reader
will increase from 15,000 units a
month to 25,000 a month
(nationwide).
What is the price elasticity of
demand for this price change for
the Kobo Mini-reader?
% change in price = -33%
% change in demand = +66%
Coefficient of PED = 2
I.e. demand is price elastic
A business that makes suitcases
aimed at holidaying tourists has
increased its prices by 5%. As a
consequence, they have seen a
drop in sales between January
and March by 15% (compared to
the same time last year)
Calculate the price elasticity of
demand and comment on the
effect on total revenue
% change in price = +5%
% change in demand = -15%
Coefficient of PED = 3
Total revenue will fall

5. Numerical Values for Coefficient of Price Elasticity
1. If Ped = 0 demand is perfectly inelastic - demand does not
change when the price changes – the demand curve is vertical
2. If Ped is between 0 and 1 (% change in demand is smaller than
the percentage change in price), then demand is inelastic
3. If Ped = 1 (% change in demand is the same as the % change in
price), then demand is unit elastic. A 15% rise in price would
lead to a 15% contraction in demand leaving total spending the
same at each price level
4. If Ped > 1 then demand responds more than proportionately to
a change in price i.e. demand is elastic. For example if a 10%
increase in price leads to a 30% drop in demand. The price
elasticity of demand for this price change is –3
Be careful when discussing ‘food’ or ‘electrical goods’ – different
classifications within these groups will have different values of
elasticity of demand and / or supply

6. What factors determine the PED of a product?
Number of close substitutes available for consumers
• The more close substitutes there are, the more price elastic the
demand e.g. many brands of breakfast cereal
Price of the product in relation to total income
• When the % of budget is high, demand is usually more price sensitive
i.e. price elastic
Cost of substituting between different products
• When substitution/switching costs are high, demand will tend to be
price inelastic
Brand loyalty and habitual consumption
• High levels of brand loyalty makes demand less price elastic
• Persuasive advertising can make demand price inelastic
Degree of necessity / luxury
• Standard assumption is that necessities have a lower price elasticity
of demand whereas luxuries are an optional spend

7. Inelastic Demand (Ped < 1)
• Following a change in
price, the total revenue
earned by the producing
firm will depend on the
PED for its product.
• If the coefficient of PED is
<1, a rise in market price
(e.g. from P1 to P2) will
lead to an increase in
total revenue for the
seller of the product.
If the co-efficient of price elasticity of demand <1, then demand is
said to be price inelastic i.e. unresponsive to a change in price
Price
Quantity
P1
P2
Q1 Q2
Demand
Increased
revenue from
selling at a
higher price
Lost revenue
from the
contraction in
quantity sold

8. Example of Inelastic Demand – Rare Earths
• China is the dominant supplier
of rare earths – producing
over 90% of world output
• The lack of close substitutes
makes demand price inelastic
• Low PED provides China with
a source of monopoly power
and creates conditions in
which China can restrict
exports of rare-earth metals
causing price to rise and
increase their total revenue
Rare-earth metals are an essential raw material in the manufacture
of solar cells and batteries and car catalysts
Projected global demand for
products containing rare earths in
2014 (% change)
Magnets 42
Batteries 13
Displays (containing phosphor) 10
Polish 10
FCC (molecule splitting) 9
Others 5
Extractive metallurgy 5
Car catalysts 4
Vitrious additives 3

9. Elastic Demand (Ped > 1)
• If demand for a product is
price elastic, a supplier
stands to gain extra
revenue if they reduce
their prices.
• The change in quantity
demanded will be
proportionately higher
than the reduction in
price. This is shown in the
diagram opposite.
If the co-efficient of price elasticity of demand >1, then demand is
said to be price elastic i.e. highly responsive to a change in price
Price
Qty
P2
P1
Q1 Q2
Demand
Increased
revenue from
selling more at
a lower price
Lost revenue
from selling at
a lower price

10. Perfectly Inelastic Demand (Ped = 0)
• A perfectly inelastic
demand curve is an
extreme case.
• It implies that consumers
are willing and able to
pay any price for the
product.
• If supply falls, equilibrium
market price can rise
without any contraction
in quantity demanded.
If the co-efficient of price elasticity of demand = zero, demand is
perfectly inelastic i.e. demand does not vary with a change in price
Price
Qty
P2
P3
Demand
P1
Q1
S1
S2
S3

11. Perfectly Elastic Demand (Ped = infinity)
• If demand is perfectly
elastic, a change in
market supply (shown on
the right as an outward
shift of supply) will not
lead to any change in the
equilibrium price.
• This demand curve
applies to highly
competitive markets
where no supplier has
any “pricing power”
If the co-efficient of PED = infinity, then demand is perfectly elastic
– there is one price at which consumers are prepared to pay
Price
Qty
P1
Demand
S1 S2
Q1 Q2

12. Unitary Elastic Demand (Ped = 1)
• With a demand curve of
unitary price elasticity, a
change in price is met
with a proportionate
change in demand
• This means that total
spending by consumers
on the product will
remain the same at each
price level
A demand curve with unitary price elasticity has a coefficient of PED
equal to 1 (unity) throughout
Price
Qty
P1
Q1 Q2
P2
Demand

13. Co-Efficient of PED along a linear demand curve
• Price elasticity of demand
along a straight line
demand curve will vary
• At high prices, a reduction
in price will have an elastic
price response – i.e. lower
prices cause total revenue
to rise
• Demand is price inelastic
towards the bottom of the
demand curve – a fall in
price causes total revenue
to drop
For a straight-lined demand curve, the PED varies along the curve
Price
Qty
P1
D
Q1
P2
Q2
A fall in market price from P1 to P2
causes total spending to rise,
therefore PED >1
P3
P4
Q3 Q4
A fall in price
from P3 to P4
causes total
spending to fall,
therefore PED <1

14. Usefulness of Price Elasticity of Demand for Producers
Firms can use PED estimates to predict:
1. The effect of a change in price on total revenue of sellers
2. The price volatility in a market following changes in supply – this
is important for commodity producers who suffer big price and
revenue shifts from one time period to another.
3. The effect of a change in an indirect tax on price and quantity
demanded and also whether the business is able to pass on
some or all of the tax onto the consumer.
PED can be used by a business for price discrimination.
• This is where a supplier decides to charge different prices for the
same product to different segments of the market e.g. peak and
off peak rail travel or prices charged by many of our domestic and
international airlines.
• Usually a business will charge a higher price to consumers whose
demand is price inelastic

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