ELASTICITY

◦ An understanding of the concept of price elasticity of demand, as the responsiveness of quantity

demanded to a change in price, along a given demand curve

◦ Learning how to calculate PED using the equation percentage change in quantity demanded / percentage
change in price

◦ An understanding that the PED value is treated as if it were positive, although its mathematical value is
usually negative.

◦ Explain, using diagrams and PED values, the concepts of price elastic demand, price inelastic demand,
unit demand, perfectly elastic demand and perfectly inelastic demand.
Key Terms
1. Price elasticity of demand (PED): The responsiveness of quantity demanded to changes in the selling
price of a good or service.
2. PED formulae: % change in quantity demanded / % change in selling price.
3. PED elastic good: A good or service where a change in the price of the product leads to a greater than
proportional change in quantity demanded.  PED elastic goods have a PED greater than 1
4. PED inelastic good: A good or service where a change in the price of the product leads to a smaller
than proportional change in quantity demanded.  PED inelastic goods have a PED less than 1
5. PED unitary good: A good or service where a change in the price of the product leads to a
proportional change in quantity demanded.  Unitary elastic goods have a PED = 1.
Activities
◦ Are there any goods and services which are either perfectly elastic or perfectly inelastic with respect to
demand?
◦
While both economic concepts exist within the IB economics course, the reality is that probably neither
exist in the real world.  The closest any product comes to a PED of 0 would be a highly addictive
substance such as Heroine or life saving medicine.
◦ Similarly, the closest that any product comes to perfectly elastic demand would be a highly competitive
market, with a large number of firms, selling largely homogenous products such as stock brokers dealing
in the purchasing and selling of shares on a stock market.
PED Elasticity and Sales Revenue
◦ Enquiry Question:
◦ What is the role of PED for firms in making decisions regarding price changes and their effect on total
revenue?
Key Points:
◦ For PED elastic goods: The sales revenue for a firm will rise when the business producing the product
reduces the price of the good or service.  This is because the additional revenue gained from increased
sales will be greater than the loss of revenue through lower prices.  Equally when the firm raises the price
of the product, revenue will fall because the additional revenue gained through higher prices will be
lower than the fall in quantity demanded at the new price level.
◦ For PED inelastic goods: The sales revenue for a firm will rise when the business raises the price of the
good or service.  This is because the additional revenue gained from higher prices will be more than than
the loss of revenue through lower sales.  Equally when the firm reduces the price of the product revenue
will fall, because the additional revenue gained through higher quantity demanded will be lower than the
fall in revenue through lower prices.
◦ For PED unitary goods: The sales revenue for a firm will be unaffected by a change in the price of the
good or service because the additional revenue gained from the  change in price will be proportional to
the loss of revenue through changing sales. 
Exam Style Questions
◦ a. Explain how firms can use the concept of price elasticity of demand to increase sales revenue. [10
marks]
◦ Defining the key terms PED elasticity and even more importantly sales revenue is key to answering this
question. 
◦ By defining sales revenue as selling price x quantity sold, a response can be set up by an explanation that
following a rise in price businesses will gain sales revenue if the fall in quantity demanded < than the
initial rise in price (PED inelastic good).
◦ Similarly a business will also gain revenue if following a fall in price the resulting increase in quantity
demanded is proportionally greater than the initial reduction in price. (PED elastic good).
◦ This should be illustrated by appropriate diagrams.
◦ Discuss the importance of price elasticity of demand for governments when intervening in different
markets. [15 marks]
◦ Discuss means to offer a considered and balanced review of the various arguments, factors or hypotheses.
◦ Governments may intervene in different markets but perhaps the most appropriate for this question is the
policy of indirect taxes and subsidies.
◦ Before placing either a sales tax or subsidy on a product they must consider the PED of the good or
service. 
◦ When governments place a sales tax on demerit goods such as cigarettes, fuel or alcoholic drinks, in an
attempt to reduce consumption rates, the impact of the tax is relatively small due to those product's PED
inelasticity.
◦ Similarly when placing a subsidy on a PED elastic good such as public transport the impact on overall
passenger numbers is considerable.
◦ (a) Explain why the price elasticity of demand for primary products tends to be lower than the
PED for manufactured goods? [10 marks]
◦ In answering this question responses should begin with a definition of price elasticity of demand,
primary products and manufactured products. PED can be described as the change in quantity
demanded for a product in response to a change in price levels. Primary products can be described as any
product which is derived from the earth and is not normally consumed directly, instead being used as the
basis for a manufactured product, which is a finished good or service, sold or consumed. Examples of
primary goods include agricultural products and commodities.
◦ Candidates should then begin their explanation of why the PED for primary commodities is normally
lower than for manufactured products
◦ This can be explained in terms of whether or not the good or service is a basic necessity or a luxury
product, plus the availability of substitutes
◦ Given the type of products produced it is more likely that primary commodities will have fewer
substitutes and many may also qualify as basic necessities. Similarly many manufactured goods are
luxury products, while in many fields such as automobiles and technology there are a range of similar
products, each competing for the consumers attentions.

◦ Responses would also be expected to illustrate their responses with diagrams to show examples of
products which are PED inelastic as well as goods which are PED elastic Candidates should also
provide examples of primary goods and manufactured products which are PED elastic / inelastic.
◦ Responses should also provide examples of exceptions to the normal rule e.g. diamonds and precious
jewels, which are PED elastic as well as cheap every day use manufactured goods which are PED
inelastic.
◦ Responses may also note that many farmers around the world are small in size and hence have little
market power to change price.

◦ An appropriate conclusion could state that while many primary products are PED inelastic in the short
run only, in the long run the PED of many primary products will increase.
◦ (b) Discuss how a change in production costs impacts on the revenue of firms producing goods with
different levels of price elasticity. [15 marks]
◦ .
Income Elasticity of Demand(YED)
◦ Explain the concept of income elasticity of demand, understanding that it involves responsiveness
of demand (and hence a shifting demand curve) to a change in income.
◦ Calculate YED using the equation percentage change in quantity demanded / percentage change in
income
◦ An understanding that normal goods have a positive value of YED while inferior goods have a
negative value of YED.
◦ Distinguish, with reference to YED, between necessity (income inelastic) goods and luxury (income
elastic) goods.
◦ Examine the implications for producers and for the economy as a whole, of a relatively low YED
for primary products, a relatively higher YED for manufactured products and an even higher YED
for services.
Key Terms
◦ Income elasticity of demand (YED) - the responsiveness of demand for a good or service following a
change in real income levels.
◦ YED formulae - % change in demand for a good or service / % change in consumer income.
◦ Normal good - a good or service with a direct relationship between income and demand, i.e a good
where demand for the product rises as income rises.
◦ Inferior good - a good or service with an inverse relationship between income and demand, i.e a good
where demand falls as income rises.
◦ YED Range of Values
◦ Goods and services with a YED value > 1 are elastic (i.e a top heavy fraction) as the % change in
demand is greater than the initial % change in income.
◦ Goods and services with a YED value > 0 but < 1 are inelastic (i.e a bottom heavy fraction) as the %
change in demand is smaller than the initial % change in income.
◦ Goods and services with a YED value = 1 have unitary elasticity as the % change in demand is equal to
the initial % change in income.
◦ Goods and services with a YED value < 0 have negative elasticity and are deemed inferior goods and
services.  Unlike normal goods the relationship between quantity demanded and consumer income is
inverse.
◦ Complete the missing summary by filling in the missing words:
◦ As a general rule basic necessity items are income or YED________, meaning that the resulting %
change in quantity demanded is ________ than the initial change in real income.  By contrast luxury
goods are normally YED ________. This means that the resulting % change in quantity demanded is
_________ than the initial change in real income. Other products may be unitary or unit elasticity.  This
means that the resulting % change in quantity demanded is ______ to the initial change in real income.
These goods are neither luxury goods or basic necessities and examples might include second hand cars
or medium luxury products.
◦ inelastic, lower, elastic, greater, equal.
Cross Elasticity of Demand
◦ Enquiry Question:
◦ What is cross elasticity of demand and what determines the XED elasticity of two related products?
◦ How might businesses use XED theory to increase sales revenue?
◦ Explain the concept of cross price elasticity of demand, understanding that it involves
responsiveness of demand for one good (and hence a shifting demand
curve) to a change in the price of another good
◦ Calculating XED using the following equation XED = % change in quantity demanded of good A x
% change in the price of good B
◦ Illustrating that substitute goods have a positive value of XED and complementary goods have a
negative value of XED
◦ Explain that the (absolute) value of XED depends on the closeness of the relationship between two
goods
◦ Examine the implications of XED for businesses if the price of either substitutes or complements
change.
Key Terms
◦ Cross elasticity of demand - this is different from other types of elasticity in economics because it
measures the relationship between two variables rather than just one.  So for example while PED
measures the responsiveness of quantity demanded to changes in price for the same product, XED
measures the responsiveness of quantity demanded to changes in price for a different product.
◦ XED formulae - % change in demand for good X / % change in price of Y.
Range Of Values
◦ Goods and service with a XED value > 0 are substitutes, because as the price of one good rises then
demand for the other also rises, ceteris parabus.
◦ Goods and services with a XED value < 0 are compliments, because as the price of one good rises then
demand for the other falls, again ceteris parabus.
◦ Products with a XED value = 0 are unrelated as the price of good X has no bearing on demand for the
other good or service. 
 (a) The diagram to the right illustrates the XED of two goods which are close
substitutes, Coke and Pepsi.  A shop owner discovers that when the price of

Activity Coke rises by 10% demand for Pepsi rose by 20%. Calculate the XED of the
two products.

(b) The shop owner also discovers that following the 10% rise in the price of Coke,
sales of bottled water rose by 5%.  Calculate the XED of Coke and bottled water.

(c) What do the two XED values tell us about the closeness of bottled water and
Pepsi as substitutes for Coke.
Answers
◦ XED of 20 / 10 = 2, meaning that the two goods are substitutes for each other. 
◦ 5 / 10 = 0.5, meaning that both products are also substitutes for each other.
◦ While any two products with a XED > 0 are substitutes  for each other, the higher the XED then the
closer the two substitutes are to each other.  Coke and Pepsi would be very close substitutes with an XED
of 2, where as bottled water only has an XED of 0.5.
 (a) The diagram to the left illustrates the XED of two goods which are
complimentary goods - Coke and potato chips.  The shop owner

Activity2
also discovers that when she increases the price of Coke by 10%,
quantity demanded for chips falls by 2%.  Calculate the XED of the
two products.

(b) The XED curve in diagram 2 slopes downwards from left to right,
explain why this is the case.

(c) Explain why the slope of the XED curve is steeper than in diagram
one?
Answers
◦ XED of -2 / 10 = - 0.2
◦ As the price of Coke rises consumers will purchase less bottles of the drink and so fewer consumers will
also purchase potato chips to eat alongside. 
◦ In diagram 1 Coke and Pespi are close substitutes.  Any change in the price of either product will result
in a more than proportional change in demand for the other.  Diagram two illustrates two complimentary
products but the connection is weaker, meaning that a change in the price of one will have a lower than
proportional change in demand for the other.