Price elasticity of demand — Edexcel A-Level Business
Test yourself on Price elasticity of demand with PEARSON EDEXCEL A-Level practice questions.
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Price elasticity of demand explained
How responsive quantity demanded is to a change in price is found by dividing the percentage change in quantity demanded by the percentage change in price, each percentage being the change divided by the original value and multiplied by one hundred.
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The result has no units and is normally negative, because price and quantity move in opposite directions. A value between zero and minus one is inelastic, so a price rise lifts total revenue; a value more negative than minus one is elastic, so a price rise cuts revenue and a discount can pay for itself. For a business the figure decides pricing: an inelastic branded line can absorb a price rise, an elastic commodity line cannot, and the same number shows how much of a cost increase can be passed on.
b) Interpretation of numerical values of price elasticity of demand
A coefficient here is a ratio rather than a percentage, and the sign is almost always negative because quantity moves the opposite way to price, so the judgement is made on the size once the sign has been set aside. Anything between zero and one means buyers have nowhere to go, so a rise in price loses proportionally less volume than it gains in margin; beyond one the same rise costs more custom than it is worth; exactly one is unitary. Petrol is often estimated near minus 0.25 in the short run while a single brand of crisps sits well past minus one, because the brand has rivals on the same shelf and the fuel does not. The figure is an estimate drawn from past data with other conditions held constant, so it ages, and it is least reliable for the large price changes managers most want to test.
c) The factors influencing price elasticity of demand
Sensitivity to price is mostly about escape routes: the more close substitutes a buyer has, the easier it is to walk away, which is why one brand of lager is far more sensitive than lager as a whole. Necessity pulls the other way, as do habit and addiction, and a purchase that swallows a large share of income is scrutinised far harder than a cheap impulse buy. Time matters as well, because households need months to switch boiler, supplier or commuting route, so demand that looks rigid this quarter loosens over a year. For a business this is a lever rather than a fixed fact, since branding, loyalty schemes and genuine differentiation are bought precisely to blunt sensitivity, and the marks lie in weighing that promotional cost against the pricing freedom it buys.
d) The significance of price elasticity of demand to businesses in terms of implications for pricing
The coefficient is the percentage change in quantity demanded divided by the percentage change in price, a pure ratio carrying no units, and its job is to tell a manager which way a price move will push revenue. Where demand is inelastic a rise in price lifts revenue and, since volume falls only slightly, lifts profit by more; where demand is elastic the profitable move is downwards, provided spare capacity exists to serve the extra units. It also settles how much of a tax or an input cost rise can be passed on, which is why a bus operator behaves quite differently from a clothing retailer. Against all that, the figure is an estimate, rivals may match a cut and turn it into a price war, and repeated rises on a loyal customer base eventually create the substitutes the firm did not have.
e) Calculation and interpretation of the relationship between price elasticity of demand and total revenue
Revenue is price multiplied by quantity sold, so any price change pulls those two halves in opposite directions and the coefficient decides which half wins. Where demand is inelastic the price effect dominates and revenue moves the same way as price; where it is elastic the volume effect dominates and revenue moves against it; at unity the two cancel and revenue is flat. The arithmetic is short: turn the percentage price change into a percentage volume change using the coefficient, apply that to the original units, then multiply by the new price and compare with the old total. A rise from two pounds to two pounds twenty on a coefficient of minus 0.5 costs five per cent of volume and still lifts takings, which is the shape examiners are looking for.
Your focus
- a) Calculation of price elasticity of demand
- b) Interpretation of numerical values of price elasticity of demand
- c) The factors influencing price elasticity of demand
Show all 5 objectives
- d) The significance of price elasticity of demand to businesses in terms of implications for pricing
- e) Calculation and interpretation of the relationship between price elasticity of demand and total revenue
Price elasticity of demand exam tips
Marking Points
- Writing the formula, percentage change in quantity demanded over percentage change in price, before substituting, so method marks survive an arithmetic slip.
- Using the original values as the denominator of both percentage changes, and either keeping the negative sign or stating clearly that the modulus is being quoted.
- Interpreting the figure rather than leaving it bare, naming it elastic or inelastic and saying what happens to total revenue at the proposed price.
- Recommending a price decision that follows from the number, with a check on how reliable the estimate is.
- Sets the negative sign aside before judging size, and says that the sign follows from the law of demand rather than being part of the magnitude
- Places the figure in the correct band, inelastic below one and elastic above one, and says what that band means for the named firm's volume when it moves price
- Converts the coefficient into an expected volume change, for example a price rise of ten per cent against a coefficient of minus 0.4 giving a fall of four per cent in units sold
- Qualifies the reading by noting that it was estimated on past data with everything else held constant
- Names a determinant and then attaches it to the case business, for example the three rival apps in the same category, rather than discussing substitutes in the abstract
- Separates the brand from the product category and says which the question concerns, since a category is nearly always less sensitive than any brand inside it
- Uses time as a determinant, distinguishing the short run when buyers are locked in from the long run when they have switched
- Argues that the firm can shift its own coefficient through differentiation and loyalty, then prices the cost of doing so
- States the ratio as percentage change in quantity demanded over percentage change in price and notes that it carries no units
- Applies the rule in the right direction, raising price where demand is inelastic and cutting where it is elastic, using the firm's own coefficient
- Follows a price cut through to capacity and contribution per unit rather than stopping at revenue, because the extra volume has to be made and delivered
- Evaluates by questioning the estimate itself, naming competitor reaction or the age of the data behind it
- Shows the revenue figure both before and after the price change, in pounds, rather than asserting a direction of travel
- Derives the new quantity from the coefficient first, applying the percentage to the original volume and never to the price
- States the rule in the right direction, with price and revenue moving together only where demand is inelastic
- Interprets the result for the business, saying whether the extra revenue survives the change in costs at the new level of output
Examiner Tips
- 💡Calculation questions carry method marks, so set out the two percentage changes on separate lines before dividing, and round sensibly, usually to two decimal places.
- 💡Expect a follow up asking whether the business should change price, where the mark scheme wants the revenue implication plus a comment on the limits of the estimate, such as resting on past data at one price point.
- 💡If the stem gives revenue before and after, use it to check the verdict, since revenue moving in the same direction as price means demand is inelastic.
- 💡Short items give the coefficient and ask for an interpretation, so answer in the form a one per cent rise in price causes a fall of so many per cent in quantity demanded, then say what that means for the firm
- 💡Longer items hand you two products with different coefficients and want a comparison, so rank them by size and say which pricing decision the evidence supports
- 💡Marks are lost when the interpretation stops at the number, so finish on revenue, contribution or capacity for the business in the extract
- 💡The usual stem gives a product and asks why its demand is more or less sensitive than a rival's, so develop two determinants with case evidence instead of listing six
- 💡In evaluation the counterweight is normally time or competitor response, so hold one of those back for the judgement paragraph
- 💡This is the standard eight or ten mark question on a named firm, so structure it as decision, supporting evidence from the extract, then the condition under which the decision would change
- 💡Where the extract gives a coefficient and a cost increase the examiner wants pass through, so say how much of the rise can be pushed onto customers and why
- 💡Calculation marks are method marks, so set out the new quantity, the new price and their product on separate lines and label the units as pounds
- 💡An interpretation sentence almost always follows, so finish with whether the firm should keep the new price and what the coefficient has assumed
Common Mistakes
- Inverting the formula and dividing the percentage change in price by the percentage change in quantity, which returns the reciprocal and the opposite verdict on revenue.
- Using the absolute changes in pounds and units instead of percentage changes, so the answer depends on the units chosen.
- Dividing by the new price rather than the original price when working out the percentage change.
- Reading a value such as minus 1.8 as weak because of the minus sign, when it is further from zero and therefore elastic.
- Reading minus 2 as smaller than minus 0.5 because it is more negative, and calling highly elastic demand inelastic
- Deciding demand is inelastic merely because sales fell after a price rise, when every downward sloping demand curve gives that and only the proportion decides the band
- Quoting a coefficient with no time frame, so a short run estimate is used to justify a permanent price increase
- Listing determinants as a memorised string with no reference to the extract, which earns knowledge credit and no application credit
- Treating price itself as a determinant, when what changes sensitivity is the alternatives available to the buyer at that price
- Assuming every luxury is elastic, when a status good with no close substitute can be strongly inelastic
- Recommending a price cut because demand is elastic without checking that contribution per unit still covers the cost of the extra volume
- Confusing revenue with profit, so a revenue gain is reported as a profit gain even where costs rise with output
- Applying a coefficient estimated for a small price change to a very large one
- Multiplying the percentage change by the price instead of the quantity, which produces a revenue figure that cannot be reconciled with the units sold
- Dropping the negative sign and adding volume after a price rise, so revenue is overstated twice over
- Taking the percentage from the new figure rather than the original, which quietly changes the base and the answer