O-Level Economics: Price Elasticity of Demand

Q: What is Price Elasticity of Demand (PED)?

PED measures how sensitive the quantity demanded of a good is to a change in its price. The formula is: PED = % change in quantity demanded / % change in price. PED is always negative (because price and demand move in opposite directions) but we use the absolute value.

Q: What makes a good elastic or inelastic?

Elastic (PED > 1): Many substitutes, luxury good, takes large % of income. Example: branded clothing. Inelastic (PED < 1): Few substitutes, necessity, habit-forming. Example: insulin, petrol, cigarettes.

Q: How does PED affect total revenue?

For ELASTIC goods: lowering price increases total revenue (because demand surges more than price falls). For INELASTIC goods: RAISING price increases total revenue (because demand barely falls). This is why governments heavily tax cigarettes — demand barely drops.

Q: What are the determinants of PED?

1) Number of substitutes (more substitutes = more elastic). 2) Necessity vs luxury (necessities are inelastic). 3) Proportion of income spent (expensive items are more elastic). 4) Time period (more elastic in the long run as consumers find alternatives). 5) Habit/addiction (addictive goods are inelastic).

A dynamic supply and demand curve diagram.

Why can the government raise cigarette tax by 50% and barely reduce smoking?

Because cigarettes have extremely INELASTIC demand (PED close to 0). This means quantity demanded is highly insensitive to price changes. Smokers are addicted — there are no close substitutes, and nicotine dependency overrides rational price sensitivity. A 50% tax increase might only reduce smoking by 5%. This is precisely why governments love taxing inelastic goods: they generate massive tax revenue with minimal behavioral change.

1. The PED Formula
2. Elastic vs Inelastic (The Spectrum)
3. The 5 Determinants of PED
4. PED and Total Revenue (The Money Question)

Price Elasticity of Demand is the most commercially practical concept in the entire CAIE Economics syllabus. Every single business pricing decision — from Netflix subscriptions to airline tickets — is driven by elasticity calculations. This guide from our Ultimate Economics Guide gives you the exam framework.

1. The PED Formula

PED = % Change in Quantity Demanded / % Change in Price

Worked Example

A cinema raises ticket prices from $10 to $12 (20% increase). Attendance falls from 500 to 350 (30% decrease).

PED = -30% / +20% = -1.5 (Elastic: |PED| > 1)

💡 Tutor's Tip

The Sign Convention: PED is always negative (Law of Demand), but CAIE frequently uses the absolute value. If the question says "PED = 1.5", they mean |PED| = 1.5 and the demand is elastic. Do NOT waste time arguing about negative signs unless the question specifically asks for the sign.

2. Elastic vs Inelastic (The Spectrum)

|PED| > 1 = Elastic: Demand is very sensitive. A small price increase causes a huge drop in sales. Example: branded clothing, restaurant meals.

|PED| < 1 = Inelastic: Demand barely reacts. People keep buying even with price hikes. Example: petrol, insulin, electricity.

|PED| = 1 = Unit Elastic: % change in demand exactly equals % change in price. Total revenue stays the same.

|PED| = 0 = Perfectly Inelastic: Demand is completely fixed regardless of price. (Life-saving drugs.)

|PED| = ∞ = Perfectly Elastic: Any price increase kills all demand instantly. (Theoretical extreme.)

3. The 5 Determinants of PED

1. Number of substitutes: More alternatives = more elastic. Pepsi is elastic because Coca-Cola exists.
2. Necessity vs Luxury: Necessities (bread, water) are inelastic. Luxuries (designer watches) are elastic.
3. Proportion of income: A 20% increase in chewing gum price is irrelevant. A 20% increase in rent is devastating. Higher income proportion = more elastic.
4. Time period: Short-run demand is usually inelastic (people can't find alternatives immediately). Long-run is more elastic.
5. Habit/Addiction: Addictive goods (cigarettes, coffee) are highly inelastic.

4. PED and Total Revenue (The Money Question)

This is the most important business application of PED and the most frequently tested.

Elastic Demand (|PED| > 1)

Lower the price → demand surges → total revenue INCREASES. This is why supermarkets have constant sales — the volume gain exceeds the per-unit price loss.

Inelastic Demand (|PED| < 1)

Raise the price → demand barely falls → total revenue INCREASES. This is why petrol companies raise prices during peak travel seasons.

📋 From the Desk of Michael O'Connor

The Exam Chain:CAIE loves multi-step evaluation questions like "Discuss whether a firm should raise its price." The A* answer chain is: 1) Identify whether the good is elastic or inelastic (give reasons using determinants). 2) Apply the revenue rule. 3) Evaluate limitations (competitors might react, long-run elasticity differs). 4) Make a justified conclusion. This 4-step chain is the framework for every 6-mark evaluation.

Frequently Asked Questions

What is Price Elasticity of Demand (PED)?▼

A measure of how sensitive demand is to price changes. PED = % change in Qd / % change in Price.

What makes a good elastic or inelastic?▼

Elastic = many substitutes, luxury, large income share. Inelastic = few substitutes, necessity, habit-forming.

How does PED affect total revenue?▼

Elastic: lower price to increase revenue. Inelastic: raise price to increase revenue.

What are the determinants of PED?▼

Substitutes, necessity vs luxury, income proportion, time period, and addiction/habit.

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