Main influences on whether demand is elastic or inelastic

Published by Patrick Mutisya · 14 days ago

IGCSE Economics 0455 – Allocation of Resources: Price Elasticity of Demand

Price Elasticity of Demand (PED)

Price elasticity of demand measures how the quantity demanded of a good or service responds to a change in its price.

The standard formula is:

\$PED = \frac{\%\Delta Q_d}{\%\Delta P}\$

Interpretation:

  • Elastic demand – PED > 1: quantity demanded changes proportionally more than the price change.

  • Inelastic demand – PED < 1: quantity demanded changes proportionally less than the price change.

  • Unitary elastic demand – PED = 1: quantity demanded changes by the same proportion as the price.

Main Influences on Whether Demand Is Elastic or Inelastic

Several factors determine the size of the PED for a particular product. The table below summarises the most important influences.

InfluenceEffect on ElasticityExplanation
Availability of close substitutesMore elasticIf consumers can easily switch to another product, a price rise will cause a large fall in quantity demanded.
Proportion of income spent on the goodMore elastic when the share is largeGoods that take up a large part of a consumer’s budget (e.g., cars) generate a stronger response to price changes.
Definition of the market (broad vs narrow)Broadly defined markets are more inelastic“Food” is a broad category with few close substitutes, whereas “cereal brand X” is narrow and more elastic.
Time horizon (short‑run vs long‑run)More elastic in the long runConsumers need time to adjust habits, find alternatives, or change production methods.
Nature of the good (necessity vs luxury)Necessities tend to be inelastic; luxuries tend to be elasticPeople will buy essential goods even if price rises, but may cut back on non‑essential items.
Brand loyalty and habit formationMore inelasticStrong brand preference reduces sensitivity to price changes.
Durability and storage possibilitiesMore elastic for non‑durable goodsPerishable items cannot be stored, so consumers react quickly to price changes.

Implications for Resource Allocation

Understanding PED helps firms and governments decide how to allocate resources efficiently:

  1. When demand is elastic, a price increase can lead to a large fall in revenue, discouraging over‑production.

  2. When demand is inelastic, producers can raise prices with little loss of sales, potentially leading to higher profits and more investment in that sector.

  3. Policy makers use PED to predict the impact of taxes or subsidies on consumption and tax revenue.

Suggested diagram: Two demand curves – one relatively steep (inelastic) and one relatively flat (elastic) – showing the same price change and the differing changes in quantity demanded.

Key Points to Remember

  • PED is a ratio of percentage changes; it is unit‑free.

  • Elasticity is not fixed; it varies with price, income, and the factors listed above.

  • Long‑run elasticities are generally larger than short‑run elasticities.

  • Policy decisions (taxes, price controls) must consider the elasticity of the affected goods.