👷 Elastic demand
Workers at a trainer factory in Varnia. Rival brands are close substitutes. A price rise loses sales fast, so workers' jobs are less secure.
Price Elasticity of Demand » Why PED Matters for Decisions
What you'll learn this session
Study time: 30 minutes
Cambridge spec: 2.6.5
- How PED affects the choices that consumers make
- Why PED matters to workers and their jobs
- How firms use PED when setting prices and dealing with higher costs
- How governments use PED when choosing which goods to tax
🔒 Unlock Full Course Content
Sign up to access the complete lesson and track your progress!
Unlock This CourseWhy PED is useful
You already know how to work out PED and what it tells you. This lesson is about what happens next. PED is not just a number for an exam. Consumers, workers, firms and governments all make better decisions when they know how strongly buyers react to a price change.
The key question each decision-maker asks is simple: if the price changes, will buyers hold on, or will they walk away?
Consumers
With so many choices on the shelf, demand is elastic - shoppers can simply switch if one brand gets pricier
For consumers, PED shows how easy it is to avoid a price rise. If demand for a good is inelastic, you have few real choices. You keep buying it, so the price rise takes more of your money. If demand is elastic, you can cut back or switch, so the price rise hurts less.
Worked example: a price rise on a necessity
In Haldor, a family spends $100 a week on fuel for the school run and work. The price of fuel rises by 10%. PED for fuel is 0.2 (inelastic), so quantity demanded falls by only 2%.
New spending = $100 x 1.10 x 0.98 = $107.80.
The family buys almost the same amount and pays more. That extra $7.80 is no longer available for other goods, such as food or clothes.
This is why a price rise on a necessity hits the household budget hardest. Lower-income households feel it most, because a larger share of their income goes on necessities. Knowing this, a sensible consumer can look for substitutes, buy in bulk when the price is low or plan spending around the goods that cannot be avoided.
Workers
Workers are affected because firms only need staff to make goods that people buy. If demand for the product is elastic, any price rise sends buyers elsewhere, so the firm sells less and may need fewer workers. Jobs are less secure. If demand is inelastic, buyers keep buying even when prices rise, so the firm's sales hold up and jobs are safer.
This also affects pay. Workers in a firm with inelastic demand can ask for higher pay with less risk, because the firm can raise its prices to cover the cost without losing many customers. Workers in a firm with elastic demand know that a price rise to pay for higher wages could lose sales, and so jobs.
👷 Inelastic demand
Workers at a water company in Varnia. Households need water and have no substitute. Sales hold up, so workers' jobs are more secure.
Producers and firms
Firms use PED for two big decisions.
1. Pricing decisions. If demand for a firm's product is inelastic, raising the price increases revenue. If demand is elastic, raising the price reduces revenue, so the firm may cut the price to sell more. A firm that knows its PED can pick the price that suits it.
2. Passing on a cost rise. When a firm's costs rise, it can try to pass on the cost by raising its price. Whether this works depends on PED.
Worked example: two firms, same cost rise
Both Brantow Gas (bottled cooking gas, PED 0.4) and Silvermere Resort (holiday stays, PED 2) face higher costs. Each raises its price by 5%.
Brantow Gas: quantity falls by 2% (0.4 x 5%). Revenue = 1.05 x 0.98 = 1.029, so revenue rises by about 2.9%. The cost rise is passed on successfully.
Silvermere Resort: quantity falls by 10% (2 x 5%). Revenue = 1.05 x 0.90 = 0.945, so revenue falls by 5.5%. Passing on the cost fails, so the resort may have to absorb the cost and accept lower profit.
In short, a firm with inelastic demand can pass on cost rises easily. A firm with elastic demand cannot, because customers switch away.
Government
Governments like taxing goods with inelastic demand, such as sugary drinks - people keep buying, so the tax raises plenty
Governments tax goods to raise money and sometimes to reduce how much people buy. PED tells them which goods to choose. (The reasons for taxation and how a tax works on a diagram come in later lessons, so here we only look at the PED link.)
💰 To raise revenue
Tax a good with inelastic demand. Buyers keep buying despite the higher price, so the government keeps collecting tax on almost the same quantity.
🏛 To cut consumption
Tax a good with elastic demand. Buyers react strongly to the higher price, so the quantity bought falls by a large amount.
Notice the problem. Many goods that governments want to discourage, such as cigarettes in many countries, have inelastic demand because they are habit-forming. A tax on them raises plenty of revenue but cuts consumption by only a little. A government that wants both more revenue and much lower consumption cannot easily have both from the same good.
Putting it together
- Consumers: with inelastic demand a price rise takes more of their budget; with elastic demand they can avoid it.
- Workers: elastic demand makes jobs less secure; inelastic demand makes them safer.
- Firms: inelastic demand lets them raise prices and pass on costs; elastic demand does not.
- Government: tax inelastic goods for revenue; tax elastic goods to cut consumption.
Common mistakes
Saying that a firm with inelastic demand "loses no customers". Demand still falls when price rises, just by a smaller percentage. Another mistake is saying that a tax on an inelastic good will greatly reduce consumption. It raises revenue but cuts quantity only a little.
Exam-style question
Prelia is a small country. Its government has put a tax on sugary drinks, which are mainly made by one large firm. After the tax, the price of a bottle rose from $2.00 to $2.20. The quantity bought fell from 1,000 to 970 bottles a week. The government says the tax is meant to raise money and to cut consumption. The firm says the tax will cost jobs.
(a) Calculate PED for sugary drinks in Prelia and state whether demand is elastic or inelastic. [3 marks]
(b) Explain one reason why demand for sugary drinks might be inelastic. [2 marks]
(c) Discuss whether this tax is likely to achieve both of the government's aims. [6 marks]
Model answer
(a) Percentage change in price = 0.20 / 2.00 x 100 = +10% (1). Percentage change in quantity = (-30 / 1,000) x 100 = -3% (1). PED = -3 / +10 = -0.3, so 0.3 ignoring the sign. Demand is inelastic because PED is less than 1 (1).
(b) Sugary drinks may be habit-forming: many people drink them regularly and find it hard to stop (1), so quantity demanded does not fall much when the price rises (1). [Other valid reasons: few close substitutes; small proportion of income.]
(c) Revenue: demand is inelastic, so quantity falls by less than the price rises and the government collects tax on most of the bottles sold, so it raises revenue (2). Cutting consumption: quantity falls by only 3%, so the tax reduces consumption only a little (2). Therefore the tax achieves the revenue aim well but the consumption aim only weakly (1). A judgement: if the government mainly wants less consumption, a tax may not be enough on its own (1). [Also credit: jobs at the firm are only slightly at risk because sales hold up.]
Exam tip
In a discussion question, always link your answer to the PED figure given in the data. Say what the number means for each aim, then give a judgement.