Definition
Price elasticity of demand (PED) measures how responsive the quantity demanded is to a change in price.
The formula:
PED = percentage change in quantity demanded ÷ percentage change in price
Because price and quantity usually move in opposite directions, PED is negative. Examiners usually refer to the absolute value.
The three cases
| Value | Name | What it means |
|---|---|---|
| PED > 1 | Elastic | Quantity responds more than price |
| PED = 1 | Unit elastic | Quantity changes in the same proportion |
| PED < 1 | Inelastic | Quantity responds less than price |
Special cases:
- Perfectly inelastic (PED = 0) — quantity does not change at all (vertical curve).
- Perfectly elastic (PED = infinity) — any price rise causes demand to fall to zero (horizontal curve).
What makes demand elastic?
Demand is more elastic when:
- there are close substitutes
- the good takes a large share of income
- it is a luxury rather than a necessity
- consumers have time to adjust
- the market is narrowly defined
Demand is more inelastic when:
- there are few substitutes
- the good is a necessity
- it takes a small share of income
- consumers have little time to adjust
- it is addictive
Why it matters for policy
Elasticity decides whether a policy actually changes behaviour.
Example — a tax on sugary drinks:
If demand is elastic, a tax raises the price and consumers switch to substitutes, so consumption falls significantly and the policy reduces the negative externality. If demand is inelastic, consumers keep buying the drink, so consumption falls only slightly and the tax mainly raises revenue.
That is evaluation, not description.
Example — a subsidy for education:
If demand is inelastic because education is compulsory, a subsidy may raise provider revenue more than it raises enrolment. The policy is more effective when demand is elastic.
Elasticity and revenue
This is a common exam question.
| Demand | Price rise | Total revenue |
|---|---|---|
| Elastic | Price rises | Revenue falls |
| Inelastic | Price rises | Revenue rises |
| Unit elastic | Price rises | Revenue unchanged |
Explain it with a chain: a price rise reduces quantity sold; if demand is inelastic, the quantity fall is proportionally smaller than the price rise, so revenue rises.
Common lost marks
- Confusing elastic with inelastic. Elastic means quantity responds a lot.
- Giving the formula but not applying it. Use it in context.
- Saying "demand is elastic" with no reason. Give the determinant.
- Forgetting the time period. Elasticity is usually higher in the long run.
- Using elasticity without a consequence. Always say what it means for the outcome.
A chain that earns marks
A tax on the good raises its price. Because the good has many close substitutes, consumers can switch easily, so demand is price elastic. The rise in price therefore causes a proportionately larger fall in quantity demanded. As a result, consumption falls significantly and the negative externality is reduced.
Quick check
- Write the PED formula.
- Name three determinants of elasticity.
- Explain why a price rise can increase revenue when demand is inelastic.
- Explain how elasticity affects the effectiveness of a tax.