Part (a): the determinants of price elasticity of demand [10]
Defining the term
Price elasticity of demand (PED) measures the responsiveness of the quantity demanded of a good to a change in its own price, calculated as the percentage change in quantity demanded divided by the percentage change in price. Demand is relatively inelastic when PED is less than one in absolute value, so quantity changes proportionately less than price, and relatively elastic when PED is greater than one, so quantity changes proportionately more than price. This answer explains the four main determinants that decide where a good's PED falls.
The number and closeness of substitutes
The single most important determinant is the availability of close substitutes. The more, and the closer, the substitutes for a good, the more elastic its demand, because consumers can switch away easily when its price rises. A particular brand of soft drink faces many close rivals, so a price rise sends buyers to competitors and quantity falls sharply, giving elastic demand. A good with no close substitute, such as petrol for a driver with a conventional car, leaves consumers little choice but to keep buying when the price rises, giving inelastic demand.
The degree of necessity
The more a good is regarded as a necessity, the more inelastic its demand, because consumers continue to buy it almost regardless of price. Basic foodstuffs, medicines and fuel for commuting are necessities with inelastic demand. Luxuries and postponable purchases, such as a foreign holiday or a new television, have more elastic demand, because consumers can do without them or delay buying when the price rises. Habit-forming goods such as tobacco are a special case of necessity for the user, which is why their demand is highly inelastic.
The proportion of income spent on the good
The larger the share of income a good takes, the more elastic its demand, because a price rise is felt more keenly and prompts consumers to economise. A box of matches or a newspaper takes a tiny share of income, so even a large percentage price rise barely registers and demand is inelastic. A car or an overseas holiday takes a large share of income, so consumers respond strongly to a price change and demand is more elastic.
Time
Demand is generally more elastic the longer the time horizon, because consumers need time to find substitutes and adjust their behaviour. When petrol prices rise, demand is inelastic at first because people still need to drive, but over years they switch to more fuel-efficient or electric cars, public transport or shorter commutes, so demand becomes more elastic.
Link back
A good's PED is therefore decided by how many substitutes it has, how necessary it is, what share of income it takes, and how much time consumers have to adjust. Goods with few substitutes, that are necessities, that take a small share of income and that consumers cannot quickly substitute away from tend to be price inelastic; goods with many substitutes, that are luxuries, that take a large share of income and that consumers can readily switch from tend to be price elastic.
Part (b): the significance of PED for firms and government [15]
Introduction
Price elasticity of demand matters because it tells decision-makers how quantity, and therefore revenue and behaviour, will respond to a change in price. This answer discusses its significance for firms, chiefly through pricing and total revenue, and for governments, chiefly through the yield and effectiveness of indirect taxes, and then evaluates how reliably elasticity can be measured and used in practice.
Significance for firms
For a firm, PED governs the link between price and total revenue, which is price multiplied by quantity. If demand is inelastic, a price rise increases total revenue, because the percentage fall in quantity is smaller than the percentage rise in price; if demand is elastic, a price rise reduces total revenue, because quantity falls proportionately more than price rises. A firm that knows its PED can therefore set price to maximise revenue: raise price where demand is inelastic, hold or cut it where demand is elastic. This is why firms invest so heavily in branding and product differentiation, which reduce the number of close substitutes and make demand more inelastic, so the firm can raise price without losing many sales. A premium smartphone maker that has built a loyal following faces relatively inelastic demand and can sustain high prices, whereas a maker of a near-identical commodity product faces elastic demand and little pricing power.
Evaluation. The usefulness of PED to a firm depends on being able to estimate it, which is hard. PED varies along a demand curve, changes over time, and is affected by rivals' reactions, which the simple measure ignores. A firm that raises price assuming inelastic demand may find rivals undercutting it, making demand more elastic than expected. PED is a guide, not a precise lever.
Significance for government
For a government, PED decides both how much revenue an indirect tax raises and how well it changes behaviour. A tax on a good with inelastic demand, such as tobacco or fuel, raises large and stable revenue, because consumers keep buying despite the higher price, and most of the tax is passed on to them. The same inelasticity, however, means the tax cuts consumption only modestly, so a tax intended to discourage a harmful good works weakly. Tobacco taxation is the developed example: because demand is highly inelastic, heavy taxes yield substantial revenue and fall mostly on consumers, yet they reduce smoking only slowly, which is why governments combine tax with advertising bans and health campaigns rather than relying on price alone. Where a government instead wants to raise consumption of a good, knowing that demand is inelastic warns it that a subsidy will have to be large to shift quantity much.
Evaluation. The government faces the same measurement problem, and a sharper version of the behaviour-versus-revenue tension. A tax that is good at raising money is, for an inelastic good, bad at changing behaviour, so the same PED that makes tobacco duty a reliable revenue source makes it a blunt public-health tool. The distributional effect matters too: taxing inelastic necessities is regressive, because they take a larger share of poorer households' incomes.
Judgement
Price elasticity of demand is significant for both firms and governments because it converts a price decision into a predictable effect on quantity and revenue. For firms it guides pricing and explains the value of building brand loyalty that makes demand inelastic; for governments it determines the revenue and the behavioural reach of indirect taxes and subsidies. The supported judgement is that PED is one of the most useful concepts in applied microeconomics, but its practical value is limited by the difficulty of measuring it accurately, by the way it shifts along the demand curve and over time, and by the fact that for an inelastic good the goals of raising revenue and changing behaviour pull in opposite directions. Elasticity is indispensable as a way of thinking, but it should inform judgement rather than be treated as a precise number.