Implications of PED for decision-making by consumers, workers, producers/firms and government

Price Elasticity of Demand (PED)

Definition: PED measures the responsiveness of the quantity demanded of a good to a change in its price. It is a key tool for analysing the decisions of consumers, workers, firms and governments.

1. Calculating PED – the Mid‑point (Arc) Method

Cambridge requires the mid‑point method because it gives the same elasticity regardless of the direction of the price change (avoids “direction‑dependence”).

Formula

\[ \text{PED}= \frac{\displaystyle\frac{Q_2-Q_1}{\frac{Q_1+Q_2}{2}}}{\displaystyle\frac{P_2-P_1}{\frac{P_1+P_2}{2}}} \]

Worked example

• Initial price \(P_1 = £10\); initial quantity demanded \(Q_1 = 200\) units.
• New price \(P_2 = £12\); new quantity demanded \(Q_2 = 170\) units.

Step‑by‑step:

\[ \% \Delta Q = \frac{170-200}{\frac{170+200}{2}} = \frac{-30}{185}= -0.1622\;(‑16.2\%) \] \[ \% \Delta P = \frac{12-10}{\frac{12+10}{2}} = \frac{2}{11}= 0.1818\;(＋18.2\%) \] \[ \text{PED}= \frac{-0.1622}{0.1818}= -0.89\;\;(\text{absolute value}=0.89) \]

Interpretation: |PED| < 1 → demand is inelastic. The 18 % price rise leads to a smaller 16 % fall in quantity demanded.

2. Classification of Demand Elasticity

Elasticity type	Absolute value of PED	Interpretation
Perfectly elastic	\(\infty\)	Any price increase makes quantity demanded fall to zero.
Elastic	\(>1\)	Quantity demanded changes proportionally more than price.
Unitary elastic	= 1	Quantity demanded changes proportionally the same as price.
Inelastic	\(<1\)	Quantity demanded changes proportionally less than price.
Perfectly inelastic	0	Quantity demanded does not change regardless of price.

3. Determinants of PED

• Availability of close substitutes – more substitutes → higher elasticity.
• Proportion of income spent on the good – larger share → higher elasticity.
• Nature of the good – luxuries are more elastic; necessities are more inelastic.
• Time horizon – demand is more elastic in the long run because consumers can adjust habits.
• Definition of the market – a narrowly defined market (e.g. “Coca‑Cola”) is more elastic than a broadly defined one (e.g. “soft drinks”).

Determinant	Effect on Elasticity	Typical Example
More close substitutes	↑ Elasticity	Brands of bottled water
Higher income share	↑ Elasticity	Cars, holidays
Luxury vs. necessity	Luxury → ↑ Elasticity; Necessity → ↓ Elasticity	Jewellery vs. bread
Longer time period	↑ Elasticity	Fuel consumption after a year
Narrow market definition	↑ Elasticity	“Apple iPhone 14” vs. “smartphones”

4. PED, Consumer Expenditure & Total Revenue

Consumer expenditure (or total spending) on a good is \(E = P \times Q\). The direction of change in expenditure after a price change mirrors the behaviour of total revenue (TR) for the seller:

Elasticity	Price rise → Effect on Expenditure / TR	Price fall → Effect on Expenditure / TR
Elastic (|PED| > 1)	Expenditure falls (quantity falls proportionally more)	Expenditure rises (quantity rises proportionally more)
Unitary (|PED| = 1)	No change	No change
Inelastic (|PED| < 1)	Expenditure rises (quantity falls proportionally less)	Expenditure falls (quantity rises proportionally less)

5. Implications for Decision‑Making

5.1 Consumers

• If demand is elastic, consumers are price‑sensitive – a small price rise leads to a large reduction in quantity bought (e.g. designer clothing).
• If demand is inelastic, consumers keep buying despite price changes (e.g. insulin, basic food staples).
• Knowledge of elasticity helps consumers decide whether to:
  • Switch to a cheaper substitute,
  • Postpone the purchase, or

5.2 Workers (Labour Market)

• Labour demand is derived from product demand. If the product’s demand is elastic, a rise in wages raises firms’ costs and they are more likely to cut employment.
• If product demand is inelastic, firms can pass higher wage costs onto consumers, so employment is relatively stable – a key point when evaluating minimum‑wage policies.
• Workers can use elasticity information to assess the risk of job loss in sectors where their product faces elastic demand (e.g. fast‑food) versus sectors with inelastic demand (e.g. utilities).

5.3 Producers / Firms

1. Pricing strategy – set price where marginal revenue = marginal cost, taking the measured PED into account.
2. Revenue maximisation – raise price when demand is inelastic; lower price when demand is elastic.
3. Output & capacity planning – forecast quantity changes using PED to avoid over‑ or under‑producing.
4. Investment decisions – evaluate how a tax, subsidy or price change will affect TR before expanding or contracting capacity.
5. Product differentiation – creating close substitutes can make demand more elastic, giving the firm more flexibility to adjust prices.
6. Cost‑pass‑through – when demand is inelastic, firms can pass a larger share of cost increases onto consumers without losing much sales.

5.4 Government

• Taxation – taxes on goods with inelastic demand (e.g. tobacco, alcohol) raise revenue with only a small fall in quantity sold; the dead‑weight loss is relatively low.
• Subsidies – most effective on elastic goods because a price reduction triggers a proportionally larger increase in quantity (e.g. electric‑vehicle subsidies).
• Price controls – a ceiling on an inelastic good (e.g. staple food) is less likely to cause a large shortage, whereas a ceiling on an elastic good can create substantial excess demand.
• Welfare analysis – elasticity determines the size of the consumer‑ and producer‑surplus changes and the resulting dead‑weight loss when a policy alters price.
• Labour‑market policy – the impact of a minimum‑wage increase depends on the elasticity of labour demand in the sector concerned.

6. Exam‑Style Case Studies

1. Tax on cigarettes – demand is relatively inelastic; a 20 % excise tax raises government revenue substantially while only modestly reducing consumption.
2. Subsidy for electric cars – demand for EVs is elastic; the subsidy lowers the effective price, leading to a large rise in sales and a shift toward greener transport.
3. Minimum‑wage rise in the fast‑food sector – labour demand is elastic; firms may cut staff hours or invest in automation, potentially increasing unemployment.
4. Price ceiling on bread during a shortage – bread is a necessity with inelastic demand; the ceiling can create a shortage (excess demand) if supply cannot meet the artificially low price.
5. VAT increase on luxury watches – demand is elastic; the price rise leads to a sharp fall in quantity sold, reducing total revenue for producers.

7. Key Takeaways

• PED quantifies how quantity demanded reacts to price changes; the absolute value determines the elasticity class.
• Determinants (substitutes, income share, nature of the good, time period, market definition) explain why some goods are more elastic than others.
• The link between PED, consumer expenditure and total revenue is central to pricing, tax, subsidy and wage‑policy decisions.
• All four groups of decision‑makers – consumers, workers, firms and government – must assess elasticity to predict outcomes and to optimise their own objectives.
• Mastering PED enables students to answer a wide range of Cambridge IGCSE/A‑Level exam questions, from precise calculations to evaluative essays.