Understanding Price Elasticity of Demand (PED) | IB Economics Guide

Understanding Price Elasticity of Demand (PED) - What Happens When Prices Change?

Ah, price changes, PED and IB Economics. Whether you're at the supermarket or online shopping for a new phone, we've all seen the "SALE!" signs. But have you ever wondered how much a price change actually influences what people buy? That's where Price Elasticity of Demand (PED) comes in. Let’s break it down in a way that’s far more interesting than your course's textbook!

What is Price Elasticity of Demand?

Imagine you’re at a café, and the price of a cappuccino suddenly jumps by 50p. How likely are you to still order it? That’s essentially what PED measures - how much demand changes when the price of a good or service changes.

• Price Elastic Demand (PED > 1.0) - Demand changes significantly when the price changes. Think of it like a seasonal sale: as prices drop, customers flood in, eager to grab bargains.

• Price Inelastic Demand (PED < 1.0) - Nothing much changes when prices rise. Essential goods, like petrol or life-saving medication, tend to be inelastic - even if the price goes up, people still buy them out of necessity.

PED Formula - The Math Bit!

Don’t worry - it’s not as bad as it sounds! Here’s the formula for calculating PED:

Percentage change in quantity demanded / Percentage change in price

(%ΔQD)/(%ΔP)

% ΔQD = Percentage change in quantity demanded

% ΔP = Percentage change in price

When calculating the % Change between two numbers:

Simply use the formula:

(New figure - Old figure) / Old figure × 100

So, when you’re figuring out if a price hike is going to send your customers running, just plug in the numbers.

Why is PED Negative?

We’ve all heard of the law of demand - as prices go up, the quantity demanded goes down. It’s a classic! Because of this law, PED usually has a negative value. When price increases, demand falls, and vice versa.

Types of Demand - From Perfectly Inelastic to Perfectly Elastic

PED isn’t just a one-size-fits-all concept. There are degrees of price elasticity:

1. Perfectly Price Inelastic Demand (PED = 0): No matter how high the price gets; people still buy the same amount. Think of insulin for diabetics - there’s no substitute.

2. Perfectly Price Elastic Demand (PED = ∞): Any price change causes demand to drop to zero. For example, if a café charges £10 for a coffee, you’d likely head to the next café instead.

3. Unit Elastic Demand (PED = 1.0): Here, a price change causes the same percentage change in demand. This is a pretty rare scenario.

Real-World Examples - Where Does PED Matter?

Price Elastic Goods:

Think of soft drinks or gadgets. If the price of your favourite cola jumps up, you might switch to a cheaper brand. These products have elastic demand.

Real-World Example: When a popular brand of mobile phones increases its prices, buyers often turn to alternatives from other brands that offer similar features for less.

Price Inelastic Goods:

On the other hand, some items, like basic utilities, are price inelastic. People don’t have much choice but to pay, even if the price increases.

Real-World Example: If the price of petrol rises, most people have little choice but to keep driving. It’s not like they can just switch to a more affordable mode of transportation if they need to get to work.

Factors Affecting PED - What Really Drives Consumer Choice?

Here’s the issue: PED is not the same for every product. There are four determinants of PED in the IB Economics syllabus that affect how responsive consumers are to price changes:

Substitutes:

The more substitutes a product has, the more elastic it becomes. For example, if the price of Coca-Cola rises, you might switch to Pepsi - there’s a clear substitute.

Necessity vs Luxury:

Necessary goods, like basic food and medicine, are inelastic. You can’t live without them, no matter the price.

Real-World Example: The demand for food items like bread stays relatively steady, even if prices rise. However, luxury items like branded handbags? Those might see a significant drop in demand if prices go up.

Income Proportion:

If a product makes up a large portion of your budget, you’re more likely to notice and be impacted by price changes. For example, you might think twice before purchasing an expensive piece of tech.

Time:

The longer people have to adjust, the more elastic the demand becomes. In the short term, people might not be able to adjust, but over time, they’ll find alternatives or adjust their behaviour.

How PED Affects Firms and Governments

Knowing about PED isn’t just for economists - firms and governments use it to make critical decisions:

• Firms can use PED to set prices optimally. For example, if demand is inelastic, they might increase the price to boost revenue. If demand is elastic, they might lower prices to increase sales.

• Governments use PED to decide how taxes affect demand for goods. For instance, sin taxes on tobacco and alcohol work because these products have relatively inelastic demand - people still buy them, even when the price rises.

By the way, sales revenue is calculated in the following way (you will need this information sooner rather than later!)

Sales revenue is calculated by price multiplied by quantity traded

(or P x Q).

So…Why is PED So Important for Decision-Makers?

Understanding PED isn’t just about acing your IB Economics exam - it’s about seeing how real-world decisions are made every day (Your best economic lessons are always what you see every day). Here’s how businesses, governments, and even entire industries use PED to guide their strategies:

Price Inelastic Demand → Increase Prices

If demand is inelastic, a price increase leads to higher total revenue. Think of life-saving medicines, petrol, or cigarettes - people will still buy them even if prices rise. Businesses and governments take advantage of this to raise funds or apply taxes.

E.g., Tobacco taxes are high because smokers tend to keep buying, even at higher prices.

Price Elastic Demand → Reduce Prices

When demand is elastic, lowering prices can attract many more buyers, boosting revenue. This is why you see discounts on branded TVs or phones - because small price drops can cause a big jump in quantity sold.

Exchange Rates & PED

Firms that export goods with price elastic demand (like fast fashion or consumer electronics) benefit from weaker currencies, as lower prices in foreign markets boost international sales.

A fall in the euro, for instance, makes Italian furniture more affordable abroad - boosting sales and jobs.

Price Discrimination

Firms often charge different prices for the same good, depending on how elastic a group’s demand is. Students and seniors often pay less for train tickets or theme parks because they’re more sensitive to price changes.

It’s all about squeezing the most revenue from different types of customers - clever, right?

Governments Use PED to Shape Policies

PED also plays a role in public policy. When the government wants to reduce harmful consumption (e.g., alcohol or cigarettes), they heavily tax products with inelastic demand, knowing the tax won’t drastically reduce consumption - but it will generate a vast amount of revenue.

That’s why a litre of petrol includes so much tax - it’s hard to cut down on driving overnight.

HL Spotlight: Why PED for Primary Commodities Is Generally Low

Here’s one of those subtle points IB Economics Examiners love to throw into HL questions:

Primary Commodities Are Price Inelastic

Raw materials like coal, wheat, or crude oil are essential in production and often have no close substitutes. That makes their demand highly inelastic - people and businesses still buy them even if prices rise.

Over Time, Demand Becomes More Elastic

In the short run, it’s hard to switch away from coal or petrol. But over time, consumers and producers adapt - e.g., buying EVs or switching to green energy. So, PED increases with time.

Manufactured Products Tend to Be More Price Elastic

Why? Because there are plenty of substitutes. You don’t have to buy an iPhone - you can choose Samsung, Google, Sony Xperia or OnePlus. Plus, these goods take up more of your income, so you notice price changes more.

In Conclusion…

Price elasticity of demand (PED) helps us understand how sensitive consumers are to price changes. Whether you're a firm trying to boost revenue or a government crafting tax policy, knowing how PED works can make all the difference.

Next time you're shopping, you’ll probably look at a price change and wonder: "Is that price elastic or inelastic?" It's not just about numbers – it’s the secret sauce behind everything from the price of your morning coffee to global commodity markets. And now, you’ve got the tools to understand why!

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