Teaching guide: price elasticity of demand

Use this teaching guide in the classroom to engage your students, contextualise the model/theory in real-world business and prepare them for the exam.

Section 3.3.2 Understanding markets and customers.

Model/theory

The value of price elasticity is of interest to managers because:

• it influences pricing decisions
  • if demand is price elastic this means it is sensitive to price. A fall in price leads to a bigger increase in quantity demanded; although the price of one unit is less the increase in sales means the total revenue earned is more
  • if demand is price inelastic this means it is insensitive to price changes. In this case a price increase will increase revenue; this is because the fall in quantity demanded is smaller than the change in price
  • if managers know the price elasticity they know what to do with price to increase revenue
• it provides useful information on the quantity demanded if price changes. This is important for deciding staffing, inventory controls and for planning cashflow and estimating profit and loss.

Note: what happens to profits (rather than revenue) will depend on the effect of a change in the quantity demanded and produced on costs not just whether revenue increases. An increase in revenue does not guarantee an increase in profits.

Problems of using the price elasticity of demand

The price elasticity of demand measures the effect on quantity demanded of a change in price, with all other factors held constant. In reality, many other factors will be changing as well, such as the income, the weather, the prices of other products and the marketing activities of this and other businesses. It might, therefore, be difficult to measure the price elasticity of demand although it may be possible to have approximate estimates (perhaps based in what has happened when the price was changed in the past).

Influences on the price elasticity of demand

• the product is heavily branded so customers are not especially sensitive to price changes
• there are few substitutes
• a relatively low proportion of income is spent on this product so customers are less sensitive to a price change
• someone else is paying so customers are less sensitive to a price change because it does not affect them directly
• in the short-term customers may not find it easy to find alternatives; over time they have longer to find alternatives and demand will be more price elastic.

Things to consider

• A price inelastic demand does not mean that quantity demanded does not change at all when price changes, just that the change in quantity demanded is less than the change in price (in percentages).
• The price elasticity of demand shows how much quantity demanded changes when price changes not when income changes (this is income elasticity of demand).

When you can use this

• This is an important concept because price changes are often suggested as a common action of a business. Students need to think through the implications of a price increase in terms of the quantity demanded (and therefore output, inventory staff levels etc), revenue and profit.
• The price elasticity of demand is relevant when analysing the impact of exchange rate changes; the impact of a strong pound, for example, depends on how sensitive exports are to higher prices in their own currencies and how sensitive imports are to a lower UK price.
• When considering marketing activities such as branding and differentiation you can examine the effect on the price elasticity of demand.

Where it's been used

• Q2, A-level paper 1, SAM set 1
• Q19, A-level paper 1, SAM set 1
• Q11, AS paper 1, 2018
• Q9, AS Paper 1, SAM set 1
• Q3, AS Paper 2, SAM set 1