PED = %Δ quantity demanded / %Δ price. Usually negative; compare its absolute value with 1.

PED and total revenue: inelastic demand?

If |PED| < 1, raising price raises total revenue; price and revenue move in the same direction.

Main determinants of PED.

Number and closeness of substitutes, necessity vs luxury, share of income spent, time period, habit/addiction.

Formula for YED and what its sign shows.

YED = %Δ quantity demanded / %Δ income. Negative: inferior. 0 to 1: normal necessity. Above 1: luxury.

Common mistake about a straight-line demand curve.

It does NOT have a constant PED. It is elastic above the midpoint, unit elastic at it and inelastic below it.

Economics

2.5 Elasticity of demand

Q: PED and total revenue: inelastic demand?

If |PED| < 1, raising price raises total revenue; price and revenue move in the same direction.

Q: Main determinants of PED.

Number and closeness of substitutes, necessity vs luxury, share of income spent, time period, habit/addiction.

Q: Formula for YED and what its sign shows.

YED = %Δ quantity demanded / %Δ income. Negative: inferior. 0 to 1: normal necessity. Above 1: luxury.

Q: Common mistake about a straight-line demand curve.

It does NOT have a constant PED. It is elastic above the midpoint, unit elastic at it and inelastic below it.

Price and income elasticities of demand measure how strongly quantity demanded responds to price and income, guiding firms' pricing and governments' tax choices. Study guide, 4 practice questions with markschemes and 5 flashcards. Free.

Price elasticity of demand and its determinants · PED and total revenue · PED along a straight-line demand curve · income elasticity: normal, inferior, luxury goods · relevance for firms and government tax revenue · (HL) PED of primary commodities vs manufactured goods · (HL) YED and sectoral change in the economy

Practise all 4 questions Study 5 flashcards

Study guide

Price elasticity of demand (PED)

PED measures how responsive quantity demanded is to a change in the good's own price.

\[\text{PED} = \frac{\%\Delta Q_d}{\%\Delta P}\]

PED is negative because of the law of demand, but economists usually discuss its absolute value.

|PED| > 1: elastic (quantity changes proportionately more than price)
|PED| < 1: inelastic
|PED| = 1: unit elastic
PED = 0: perfectly inelastic (vertical demand curve)
PED = infinity: perfectly elastic (horizontal demand curve)

Determinants of PED

Number and closeness of substitutes: more and closer substitutes make demand more elastic. A specific brand is more elastic than the product category.
Necessity versus luxury: necessities tend to be inelastic.
Share of income spent: goods taking a small share of income (salt, matches) are inelastic.
Habit or addiction: cigarettes and coffee tend to be inelastic.
Time: demand becomes more elastic over time as consumers find alternatives.

PED and total revenue

Total revenue (TR) = P × Q.

If demand is inelastic, raising price raises TR.
If demand is elastic, raising price lowers TR.
If unit elastic, TR is unchanged.

Worked example: a museum raises its ticket from USD 4 to USD 5 (+25%). Monthly visits fall from 100 to 85 (−15%). PED $= -15 / 25 = -0.6$: inelastic. TR rises from USD 400 to USD 425, so the price rise was a sensible revenue decision.

PED along a straight-line demand curve

On a linear demand curve the slope is constant but PED is not. Near the top (high price, low quantity) demand is elastic; at the midpoint PED = 1 and TR is at its maximum; near the bottom it is inelastic. Diagram in words: a downward straight-line D with the upper half labelled elastic, the midpoint unit elastic, the lower half inelastic; beneath it a TR curve shaped like a hill peaking at the midpoint quantity.

(HL) example: $Q_d = 60 - 2P$. From P = 10 to 12, Q falls from 40 to 36: PED $= -10\% / 20\% = -0.5$. From P = 20 to 22, Q falls from 20 to 16: PED $= -20\% / 10\% = -2$. TR peaks at the midpoint P = 15, Q = 30, TR = USD 450.

Income elasticity of demand (YED)

\[\text{YED} = \frac{\%\Delta Q_d}{\%\Delta Y}\]

YED > 1: luxury (income elastic) normal good
0 < YED < 1: necessity (income inelastic) normal good
YED < 0: inferior good

Example: incomes rise 5%, spending on restaurant meals rises 8%: YED = 1.6, a luxury.

Relevance for firms and government

Firms use PED to set prices and YED to plan for booms and recessions. Governments place indirect taxes on goods with inelastic demand (fuel, tobacco, alcohol) because quantity barely falls, so revenue is high and reliable, and most of the burden falls on consumers.

(HL) Commodities and sectoral change

Primary commodities (wheat, coffee, oil) tend to have low PED because they are necessities or essential inputs with few substitutes. Combined with supply shocks, this causes large price swings and unstable farm incomes. Manufactured goods usually have more substitutes and higher PED.

Food has a low YED, while services such as travel and finance have higher YEDs. As economies grow, spending shifts from agriculture to manufacturing and then to services, so the primary sector shrinks as a share of output.

Common mistakes

Inverting the formula (price change on top).
Using the slope of the curve as elasticity.
Calling a good "elastic" because PED is negative.
Forgetting the sign of YED, which matters: it distinguishes normal from inferior goods.

Exam tips

10-mark questions: explain using a diagram, for example two demand curves of different steepness showing the different effect of the same price rise on quantity and on TR (show revenue as rectangles).
15-mark questions: evaluate the usefulness of PED/YED: estimates are based on past data, ceteris paribus rarely holds, and elasticity varies along the curve and over time.
Always state the conclusion: "PED = −0.6, so demand is price inelastic."

Cheat sheet

Measure	Formula	Key values
PED	$\%\Delta Q_d / \%\Delta P$	>1 elastic, <1 inelastic, =1 unit, 0 perfectly inelastic
YED	$\%\Delta Q_d / \%\Delta Y$	>1 luxury, 0–1 necessity, <0 inferior

$\%\Delta = \frac{\text{new} - \text{old}}{\text{old}} \times 100$
Inelastic: P ↑ → TR ↑ · Elastic: P ↑ → TR ↓ · Unit: TR constant
Linear D: elastic above midpoint, PED = 1 at midpoint (TR max), inelastic below
Determinants: substitutes, necessity, share of income, habit, time
Government taxes inelastic goods → high revenue, consumers bear more of the tax
HL: commodities have low PED → volatile prices · low YED for food → primary sector share falls with growth

Key definitions

Price elasticity of demand: A measure of how responsive quantity demanded is to a change in the good's own price.
Price elastic demand: Demand where the percentage change in quantity demanded is larger than the percentage change in price, so |PED| > 1.
Price inelastic demand: Demand where the percentage change in quantity demanded is smaller than the percentage change in price, so |PED| < 1.
Unit elastic demand: Demand where quantity changes by the same percentage as price, so total revenue does not change.
Total revenue: The total income a firm receives from sales, equal to price times quantity sold.
Income elasticity of demand: A measure of how responsive quantity demanded is to a change in consumers' income.
Luxury good: A normal good with income elastic demand, YED greater than 1.
Necessity good: A normal good with income inelastic demand, YED between 0 and 1.
Primary commodity (HL): A raw material or agricultural product, such as copper or cocoa, that has had little or no processing.

Practice questions

SLPaper 2Standard

Question 1

Extract: Fare rise holds up

When the bus company in Larkton raised its standard fare from $2.00 to $2.50, monthly journeys fell from 40,000 to 36,000. Managers said many passengers had no practical alternative for getting to work.

(a) [2]

Define the term price elasticity of demand (PED).

Markscheme

1 A measure of the responsiveness of quantity demanded of a good
1 to a change in its own price

(b) [2]

Calculate the PED for bus journeys.

Markscheme

1 %ΔQ = −10%, %ΔP = +25%
1 PED = −0.4 (accept 0.4)

(c) [2]

Calculate the change in the company's monthly revenue from fares.

Markscheme

1 Before: 40,000 × $2.00 = $80,000; after: 36,000 × $2.50 = $90,000
1 Revenue increases by $10,000

(d) [4]

Using a diagram, explain why revenue rose despite fewer journeys.

Markscheme

1 Diagram with a steep (inelastic) demand curve and price rise from $2.00 to $2.50
1 Revenue gained and revenue lost areas identified
1 Explains that demand is price inelastic (|PED| < 1)
1 so the percentage fall in quantity is smaller than the percentage rise in price and the gain area exceeds the loss area

SLPaper 2Standard

Question 2

Household incomes in Brenmark rose by 5% last year. Over the same period, quantity demanded of instant noodles fell by 3% while quantity demanded of restaurant meals rose by 12%.

(a) [2]

Calculate the income elasticity of demand (YED) for each good.

Markscheme

1 Instant noodles: −3% / 5% = −0.6
1 Restaurant meals: 12% / 5% = 2.4

(b) [2]

Using your answers, classify each good.

Markscheme

1 Instant noodles: inferior good (negative YED)
1 Restaurant meals: normal good and a luxury (YED > 1)

(c) [4]

Explain why a restaurant chain might find YED information useful when a recession is forecast.

Markscheme

1 In a recession incomes fall
1 With YED of 2.4, demand would fall by a larger percentage than income
2 The chain could plan by cutting planned expansion, adjusting stock or staff, or offering lower-priced menu items

HLPaper 1Challenging

Question 3

(a) [10]

Explain why the price elasticity of demand for primary commodities tends to be lower than for manufactured products.

Markscheme

1 Defines the key economic terms used in the question accurately
2 Diagrams contrasting a steep demand curve for a commodity and a flatter one for a manufactured good
2 Explains that many commodities (food, fuel, raw materials) are necessities
2 Explains that commodities have few close substitutes, while manufactured goods are often branded and highly substitutable
2 Explains the consequence: commodity price changes cause large revenue swings for producers
1 Uses a real example, e.g. crude oil or wheat

(b) [15]

Evaluate the importance of price elasticity of demand for a government deciding which goods to tax.

Markscheme

1 Defines indirect tax and PED
2 Diagram showing a tax on a good with inelastic demand: large revenue, small fall in quantity
3 Explains that inelastic demand gives predictable, high tax revenue with small output effects
2 Uses a real-world example, e.g. fuel or tobacco taxes
2 Evaluates: if the aim is to reduce consumption of a demerit good, inelastic demand makes the tax less effective
2 Evaluates: taxes on inelastic necessities are often regressive and hit low-income households
2 Evaluates: PED estimates may be inaccurate and change over time
1 Reaches a supported conclusion

Key facts

Formula for PED.: PED = %Δ quantity demanded / %Δ price. Usually negative; compare its absolute value with 1.
PED and total revenue: inelastic demand?: If |PED| < 1, raising price raises total revenue; price and revenue move in the same direction.
Main determinants of PED.: Number and closeness of substitutes, necessity vs luxury, share of income spent, time period, habit/addiction.
Formula for YED and what its sign shows.: YED = %Δ quantity demanded / %Δ income. Negative: inferior. 0 to 1: normal necessity. Above 1: luxury.
Common mistake about a straight-line demand curve.: It does NOT have a constant PED. It is elastic above the midpoint, unit elastic at it and inelastic below it.

Measure	Formula	Key values
PED	\(\%\Delta Q_d / \%\Delta P\)	>1 elastic, <1 inelastic, =1 unit, 0 perfectly inelastic
YED	\(\%\Delta Q_d / \%\Delta Y\)	>1 luxury, 0–1 necessity, <0 inferior