Demand (HSC SSCE Economics): Revision Notes

Price Elasticity of Demand

What is price elasticity of demand?

Price elasticity of demand (PED) measures how responsive consumers are when the price of a product changes. Specifically, it shows the percentage change in quantity demanded following a one per cent change in price.

Understanding this concept helps answer a crucial question: when prices change, how much does the quantity demanded change? The answer varies significantly between different products and situations.

Types of elasticity

There are three main categories of price elasticity, each describing a different level of consumer responsiveness to price changes.

Elastic demand occurs when consumers show a strong response to price changes. The percentage change in quantity demanded is greater than the percentage change in price. For example, if a restaurant increases its prices by 10%, and demand falls by 20%, this demonstrates elastic demand.

Inelastic demand occurs when consumers show a weak response to price changes. The percentage change in quantity demanded is smaller than the percentage change in price. For instance, if petrol prices increase by 10% but consumption only falls by 3%, demand is inelastic.

Unit elastic demand represents the middle ground, where the percentage change in quantity demanded exactly matches the percentage change in price. This means total consumer spending remains constant despite the price change.

Why price elasticity matters

For businesses

Understanding PED is essential for developing effective pricing strategies. When demand is elastic, lowering prices leads to a proportionally larger increase in sales volume, which boosts total revenue. Conversely, when demand is inelastic, businesses can increase prices without losing many customers, again increasing total revenue.

Firms often invest in market research to determine the price elasticity of their products at different price points. This knowledge guides decisions about pricing adjustments and helps predict how competitors' price changes might affect their own sales.

For government

Governments need to understand PED for two key purposes. First, when setting prices for public services like transport or utilities, they must predict how demand will respond to fare changes. Second, when imposing indirect taxes (such as excise duties on alcohol, tobacco, or fuel), they need to estimate the revenue these taxes will generate.

Governments typically target goods with inelastic demand for excise taxation. Why? Because consumers continue purchasing these products even when prices rise, ensuring stable tax revenue. If an excise tax were placed on a product with elastic demand, the resulting price increase would cause a sharp drop in sales, reducing the expected tax revenue.

Measuring price elasticity: the total outlay method

The total outlay method provides a straightforward way to determine whether demand is elastic, inelastic, or unit elastic. This method examines what happens to total revenue (also called total outlay or total expenditure) when prices change.

Total outlay is calculated as:

$\text{Total Outlay} = \text{Price} \times \text{Quantity demanded}$

The relationship between price changes and total outlay reveals the type of elasticity:

Working through examples

The following table demonstrates how to apply the total outlay method across different price ranges:

Understanding demand curves and elasticity

Why slope doesn't tell the whole story

At high prices (upper part of the curve), demand tends to be elastic because consumers are more sensitive to price changes. At low prices (lower part of the curve), demand tends to be inelastic because the absolute price changes become less significant to consumers.

The diagram above shows three demand curves with identical slopes but positioned at different distances from the origin. Applying the total outlay method to a price change from $4 to $3 reveals:

• On curve $D_1D_1$: Total outlay rises from $40 to $60 → demand is elastic
• On curve $D_2D_2$: Total outlay remains at $120 → demand is unit elastic
• On curve $D_3D_3$: Total outlay falls from $280 to $240 → demand is inelastic

This demonstrates that identical slopes can produce different elasticities depending on the price-quantity combination.

Extreme cases of elasticity

Two theoretical extremes of elasticity help illustrate the boundaries of consumer responsiveness. While rarely observed in perfect form across entire markets, understanding these cases clarifies the concept of elasticity.

Perfectly elastic demand

Perfectly elastic demand occurs when consumers will purchase unlimited quantities at a specific price, but nothing at any higher price. The demand curve appears as a horizontal line.

Perfectly inelastic demand

Perfectly inelastic demand occurs when consumers purchase the same quantity regardless of price. The demand curve appears as a vertical line.

Factors determining elasticity of demand

Five key factors influence how elastic or inelastic demand will be for any particular product. Understanding these factors helps predict consumer behaviour and design appropriate pricing strategies.

Necessities versus luxuries

Products considered essential for daily life exhibit inelastic demand. Even when prices rise, consumers continue purchasing necessities like bread, milk, or basic utilities because they have limited alternatives. The quantity demanded doesn't fall significantly.

Luxury goods and services show more elastic demand. Items like fine dining, designer clothing, or holiday travel are discretionary purchases. When prices increase, consumers can simply choose not to buy these items or postpone purchases, causing a larger proportional decrease in quantity demanded.

Availability of substitutes

The existence of close substitutes is perhaps the most important determinant of elasticity. Products with many substitutes have highly elastic demand because consumers can easily switch to alternatives when prices rise.

Conversely, products with few or no substitutes have inelastic demand. The local water supply has no real substitute—if prices increase, consumers have limited options and must continue purchasing roughly the same amount. Quantity demanded falls only slightly.

Proportion of income spent

When a product represents only a tiny fraction of total income, demand tends to be inelastic. Most consumers won't refuse to buy chewing gum or disposable pens because of a 10% price increase—the absolute cost difference is too small to matter.

However, major purchases that consume a significant portion of income show more elastic demand. A 10% increase in car prices or housing costs might cause many consumers to delay purchases, seek alternatives, or choose cheaper models. The larger the proportion of income involved, the more carefully consumers evaluate price changes.

Time elapsed since the price change

Elasticity tends to increase over time as consumers have more opportunity to adjust their behaviour. Immediately after a price increase, quantity demanded may not change much because consumers need time to:

• Become aware of the price change
• Research and identify alternatives
• Change consumption habits
• Make practical adjustments

The durability of goods also affects how elasticity changes over time. For durable goods like cars or appliances, an initial price rise causes very elastic demand as consumers postpone replacement and repair existing items instead. However, this elasticity eventually decreases as old items must eventually be replaced regardless of price.

Habit-forming characteristics

Products that are addictive or habit-forming typically exhibit inelastic demand. Consumers of tobacco and alcohol tend to maintain consumption levels even when prices increase substantially. The psychological and physical dependence reduces their responsiveness to price changes.