• PRICE ELASTICITY OF DEMAND (PED) refers to... 

• "...a measure of the responsiveness of the quantity demanded of a good to changes in the price of the good."

• NOTE: IB uses the original value method, which treats a % change differently depending on whether it is rising or falling, whereas the midpoint method suggests treating both changes the same. 

-------METHOD 1-------

For a % increase: [(New Price - Old Price)/Old Price] x 100.

For a % decrease: [(Old Price - New Price)/Old Price] x 100.

-------EXAMPLE-------

Price rises from $5 to $8? $8-$5/$5 * 100 = 60%*

Price rises from $8 to $5? $8-$5/$8 * 100 = 24%*

*Note this method produces DIFFERENT RESULTS DEPENDING ON THE DIRECTION OF CHANGE.  

-------METHOD 2: ('THE MIDPOINT METHOD')-------

The midpoint formula computes % changes by DIVIDING the CHANGE by the AVERAGE VALUE (i.e., the midpoint) of the INITIAL and FINAL value. As a result, it produces the SAME RESULT REGARDLESS OF THE DIRECTION OF CHANGE.

-------EXAMPLE-------

Price rises from $5 to $8? $3/$6.5 * 100 = 46%

Price rises from $8 to $5? $3/$6.5 * 100 = 46%

• Since price and quantity demanded are negatively (indirectly) related, the PED IS A NEGATIVE NUMBER. For example, any percentage INCREASE IN PRICE (A POSITIVE DENOMINATOR), means a percentage DECREASE IN QUANTITY DEMANDED (A NEGATIVE NUMERATOR), leading to a NEGATIVE PED and vice versa. It is however common practice is to drop the minus sign and consider PED as a positive number. (In mathematics this is called taking the absolute value.) 

• If we use '% CHANGE IN PRICE' and '% CHANGE IN QUANTITY DEMANDED' as the units to illustrate elasticity, then: 

  • INELASTIC curves are STEEP lines.

  • ELASTIC curves are SHALLOW lines. 

  • UNIT ELASTIC curves are 'RECTANGULAR HYPERBOLAS'. 

  • PERFECTLY INELASTIC curves are PERPENDICULAR TO X-AXIS.

  • PERFECTLY ELASTIC curves are PERPENDICULAR TO Y-AXIS.

• TOTAL REVENUE (TR) is the amount of money received by firms when they sell a good (or service), and is equal to the PRICE (P) of the good times and the QUANTITY (Q) OF THE GOOD SOLD. Therefore, 

--TR = P × Q--

• WE CAN SEE THAT AS THE PRICE IS LOWERED THE TOTAL REVENUE INITIALLY STARTS TO RISE, THEN PEAKS BEFORE FALLING, AND VICE-VERSA.

• WE CAN SEE THAT THERE WILL ALWAYS COME A PRICE LEVEL BEYOND WHICH SELLING A LARGER QUANTITY AT A LOWER PRICE WILL GENERATE LESS TOTAL REVENUE THAN SELLING A SMALLER QUANTITY AT A HIGHER PRICE AND VICE VERSA.

• WE CAN CLEARLY SEE THAT WHEN THE PED IS ELASTIC,...

  • LOWERING THE PRICE RESULTS IN INCREASING TOTAL REVENUE, AND 

  • RAISING THE PRICE RESULTS IN DECREASING TOTAL REVENUE.

• WE CAN CLEARLY SEE THAT WHEN THE PED IS INELASTIC,... 

  • LOWERING THE PRICE RESULTS IN DECREASING TOTAL REVENUE, AND 

  • RAISING THE PRICE RESULTS IN INCREASING TOTAL REVENUE.

If the price range is in the ELASTIC PORTION (PED >1)

-IF THE PRICE RISES TR FALLS. 

-IF THE PRICE FALLS TR RISES. 

If the price range is in the INELASTIC PORTION (PED <1)

-IF THE PRICE RISES TR RISES. 

-IF THE PRICE FALLS TR FALLS. 

• To illustrate an ELASTIC price change we use HIGHER PRICE RANGES.

• To illustrate an INELASTIC price change we use HIGHER LOWER RANGES.

•  "We want more total revenue, should we raise or lower our prices or keep prices the same?" 

• "If the price range is inelastic then we can afford to raise prices and lose a few customers, as total revenue will still rise."

• "If the price range is elastic then we can lower prices and gain a large number of orders, and total revenue will still rise."

• "If the price range is unitary elastic then there is no need to change price as total revenue will stay the same."

• "We need more revenue fast, so let's tax those goods that consumers will still pay for even though the price has risen. This way we make stable revenue, and employment won't suffer too much."

• Knowledge of PED is useful to the government because if they PLACE INDIRECT TAXES (like sales tax, VAT, or excise duties) ON GOODS WITH INELASTIC DEMAND, then the tax revenue they collect is relatively high and the fall in output will have a minimal impact on employment levels.

• "We want to reduce consumption of these goods; if it's inelastic, a tax won't have much impact, so we need to think of alternative strategies."

• If a DEMERIT GOOD is found to have inelastic demand, such as cigarettes, then an INDIRECT TAX will not result in much of a reduction in consumption on its own; therefore, governments tend to combine indirect taxation with other methods to reduce consumption, such as plain packaging, negative advertising, and bans.

• "We want to increase production and consumption of these goods; if it's elastic, a subsidy will have a significant impact."

• Similarly, if a MERIT GOOD is found to have elastic demand, then a government SUBSIDY will have a significant impact on quantity consumed.

• "This essential good is inelastic; the producers can raise the price, and people will still need to pay. This isn't fair for low-income people; we need to fix a maximum price, or people may suffer."

• If an ESSENTIAL good such as electricity or water is found to have inelastic demand, then a government can make it affordable to poorer households by introducing a MAXIMUM PRICE.