IGCSE Economics 0455 – Allocation of Resources: Price Changes
Allocation of Resources – Price Changes
Objective
To understand how changes in price affect the quantity of a good or service sold and to analyse the factors that influence this relationship.
Key Concepts
Law of Demand: All other things being equal, when the price of a good falls, the quantity demanded rises, and when the price rises, the quantity demanded falls.
Demand Curve: A graphical representation of the relationship between price and quantity demanded, typically downward‑sloping.
Price Elasticity of Demand (PED): Measures the responsiveness of quantity demanded to a change in price.
Price Elasticity of Demand
The formula for PED is:
\$\$
\text{PED} = \frac{\%\ \text{change in quantity demanded}}{\%\ \text{change in price}}
\$\$
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.
Unit‑elastic demand (|PED| = 1): Quantity demanded changes exactly in proportion to the price change.
Factors Influencing Price Elasticity
Factor
Effect on Elasticity
Availability of close substitutes
More substitutes → more elastic
Proportion of income spent on the good
Higher proportion → more elastic
Time period considered
Longer time → more elastic
Nature of the good (luxury vs necessity)
Luxuries are more elastic; necessities are more inelastic
Definition of the market (broad vs narrow)
Narrowly defined markets are more elastic
Effect of Price Changes on Sales
Sales revenue (SR) is calculated as:
\$\$
SR = P \times Q
\$\$
Where P is price and Q is quantity sold. The impact of a price change on SR depends on the elasticity of demand:
Elastic demand (|PED| > 1): A price decrease leads to a proportionally larger increase in quantity, raising total revenue. A price increase reduces revenue.
Inelastic demand (|PED| < 1): A price increase leads to a proportionally smaller decrease in quantity, raising total revenue. A price decrease reduces revenue.
Unit‑elastic demand (|PED| = 1): Changes in price do not affect total revenue; the increase in price is exactly offset by the decrease in quantity (and vice‑versa).
Practical Example
Suppose a retailer sells 1,000 units of a product at \$10 each, giving a sales revenue of \$10,000. If the price is reduced to \$8 and the quantity demanded rises to 1,500 units, the new revenue is \$12,000.
Calculate PED:
\$\$
\%\Delta P = \frac{8-10}{10}\times100 = -20\%\\[4pt]
Because demand is elastic, the price cut increased total revenue.
Suggested Diagram
Suggested diagram: Demand curve showing an elastic segment (steeper) and an inelastic segment (flatter). Mark two price points (P1, P2) and corresponding quantities (Q1, Q2) to illustrate the effect on total revenue.
Key Points to Remember
The direction of the change in total revenue depends on whether demand is elastic or inelastic.
Understanding the factors that affect elasticity helps firms set optimal pricing strategies.
Short‑run and long‑run elasticities can differ; businesses should consider the time horizon when evaluating price changes.