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VCE Economics (Year 11) · Unit 1 — Markets and Resource Allocation · 16m read

Elasticity — Price Sensitivity

Ever wondered why a coffee shop can raise prices without losing customers, but a petrol station can't? That's price elasticity — basically, how sensitive customers are to price changes. You'll learn to calculate whether a price rise helps or hurts a business's profits, and why governments care about elasticity when deciding on taxes and policies. It's the tool that explains real markets in action.

Learning objective: Calculate and interpret price elasticity of demand and explain its implications for businesses and government.

By the end of this lesson you can:

  • I can calculate PED using the formula and interpret the result.
  • I can identify factors that make demand elastic or inelastic.
  • I can explain how PED affects total revenue and tax incidence.

Elasticity is how squishy demand is. Inelastic demand (petrol) barely squishes when price rises; elastic demand (holidays) squishes a lot.

Price elasticity of demand — measuring responsiveness

### Definition

Price elasticity of demand (PED) measures the percentage change in quantity demanded in response to a 1% change in price.

$$PED = \frac{\% \Delta Q_d}{\% \Delta P} = \frac{\Delta Q_d / Q_d}{\Delta P / P}$$

Since demand curves slope downward, PED is always negative. In practice, we often work with the absolute value $|PED|$.

### Interpreting PED

| $|PED|$ | Description | Meaning |
|---------|-------------|---------|
| $|PED| > 1$ | Elastic | Consumers very responsive; % change in Q > % change in P |
| $|PED| = 1$ | Unit elastic | % change in Q = % change in P |
| $|PED| < 1$ | Inelastic | Consumers less responsive; % change in Q < % change in P |
| $|PED| = 0$ | Perfectly inelastic | No response to price change (e.g., insulin) |
| $|PED| = \infty$ | Perfectly elastic | Infinite response — any price rise → Q = 0 |

### Determinants of PED

Demand tends to be MORE elastic when:
- Many close substitutes available
- The good is a luxury or non-necessity
- Large proportion of income spent on the good
- More time to adjust (long-run vs short-run)
- Narrowly defined (e.g., "Coca-Cola" vs "soft drinks")

Demand tends to be MORE inelastic when:
- Few substitutes (addictive goods, medication)
- Necessity (bread, electricity)
- Small proportion of income
- Short time period

### PED and total revenue

$$TR = P \times Q$$

| Demand type | Price rises | Price falls |
|-------------|-------------|-------------|
| Elastic ($|PED| > 1$) | TR falls | TR rises |
| Inelastic ($|PED| < 1$) | TR rises | TR falls |
| Unit elastic | TR unchanged | TR unchanged |

Why? If demand is elastic, the % fall in Q is larger than the % rise in P → revenue falls.

Elasticity Formulas

  • PED: PED = \dfrac{\% \Delta Q_d}{\% \Delta P} (Always negative (demand law))
  • PED calculation: PED = \dfrac{\Delta Q / Q}{\Delta P / P} = \dfrac{\Delta Q}{\Delta P} \times \dfrac{P}{Q}
  • Total revenue: TR = P \times Q (Use to check elastic/inelastic prediction)

Key ideas at a glance

  • PED = %ΔQd / %ΔP: Formula.
  • Elastic > 1: Responsive.
  • Inelastic < 1: Unresponsive.
  • Determinants: Substitutes, necessity, proportion of income.

Worked example (Medium)

When the price of petrol rises from $2.00 to $2.20 per litre, quantity demanded falls from 1,000 L to 920 L per week. Calculate PED and classify demand.

  1. Calculate % ΔP. \%\Delta P = \frac{2.20 - 2.00}{2.00} \times 100 = +10\%
  2. Calculate % ΔQ. \%\Delta Q_d = \frac{920 - 1000}{1000} \times 100 = -8\%
  3. Calculate PED. PED = \frac{-8\%}{+10\%} = -0.8
  4. Classify. $|PED| = 0.8 < 1$ → demand is inelastic. Quantity demanded fell by a smaller percentage than the price rise.

Answer: PED = −0.8; demand is inelastic. This makes sense for petrol — few immediate substitutes, necessity for most drivers.

Worked example (Hard)

The Victorian government increases the tobacco excise by $5 per packet. PED for tobacco is 0.4. Current price: $40/packet. Current consumption: 50 million packets/year. Calculate (a) the new approximate consumption level and (b) the government's excise revenue, and (c) evaluate the policy's effectiveness.

  1. Calculate quantity change. Price increase: $5/$40 = 12.5%. PED = 0.4 means a 12.5% price rise causes a 5% quantity decrease. \Delta Q = 0.4 \times 12.5\% = 5\%
  2. New consumption. Q_{new} = 50M \times (1 - 0.05) = 47.5M \text{ packets}
  3. Excise revenue. Assuming the full $5 tax is added to price (most of tax borne by consumer since PED < 1): \text{Revenue} = 47.5M \times \$5 = \$237.5M
  4. Policy evaluation. HEALTH objective: modest — only 5% reduction in consumption. Tobacco demand is INELASTIC (addictive). The tax is better at raising revenue than reducing consumption. REVENUE objective: highly effective — $237.5M with minimal market disruption. EQUITY concern: the tax is REGRESSIVE — lower-income smokers pay a higher proportion of their income. Policy is effective for revenue, limited for health, problematic for equity.

Answer: Consumption falls 5% (to 47.5M packets). Revenue = $237.5M. The tax is more effective for revenue than for reducing smoking (inelastic demand). Equity concern: regressive burden on lower-income smokers.

Common mistakes

  • Classifying elasticity based on the numerical sign rather than the absolute value PED is technically negative (price up → quantity down), but we use ABSOLUTE values for classification. Students sometimes write "|PED| = -0.4, which is less than 1, so elastic" — confusing the sign with the magnitude. Fix: Always use absolute value. |PED| < 1 = INELASTIC. |PED| > 1 = ELASTIC. |PED| = 1 = UNITARY. Ignore the negative sign entirely for classification purposes.
  • Claiming that inelastic demand means quantity does not respond to price AT ALL Inelastic means quantity responds PROPORTIONALLY LESS than price — not that it doesn't respond. PED = 0.4 means a 10% price rise causes a 4% quantity fall. Only PERFECTLY inelastic (PED = 0) means zero quantity response. Fix: Be precise: "Demand is inelastic (PED = 0.4), meaning quantity demanded decreases, but by a smaller proportion than the price increase. A 10% price rise causes only a 4% quantity reduction."

Elasticity and Business Strategy — Pricing Power

Understanding elasticity is not just academic — it directly determines business pricing strategy and government tax policy. For VCE Economics, connecting elasticity to real-world decision-making demonstrates analytical depth.

Business pricing strategy:
If demand for your product is INELASTIC (PED < 1):
- Raising prices INCREASES total revenue (quantity falls less than price rises).
- Examples: petrol, prescription medicines, electricity, cigarettes. These businesses have PRICING POWER.
- Strategy: raise prices gradually; invest in brand loyalty to reduce substitutability.

If demand is ELASTIC (PED > 1):
- Raising prices DECREASES total revenue (quantity falls more than price rises).
- Examples: restaurant meals, clothing brands, holiday travel. These businesses face PRICE COMPETITION.
- Strategy: compete on price; differentiate to reduce elasticity (branding, loyalty programs).

What determines elasticity?
The key determinant is SUBSTITUTABILITY:
- More substitutes → more elastic (consumers switch easily).
- Fewer substitutes → less elastic (consumers are "captive").
- Time matters: demand is more elastic in the long run (consumers find alternatives).

Government tax policy:
Governments tax inelastic goods (tobacco, alcohol, petrol) because:
1. Revenue is PREDICTABLE — quantity barely falls, so revenue is stable.
2. DEADWEIGHT LOSS is small — minimal market distortion.
3. The tax falls mainly on CONSUMERS (inelastic side bears more of the tax burden).

Cross-price elasticity: Measures how demand for one good responds to price changes of another. Positive cross-elasticity = SUBSTITUTES (Coke and Pepsi). Negative = COMPLEMENTS (printers and ink cartridges).

VCE application: When discussing elasticity, always connect the numerical value to a REAL-WORLD IMPLICATION (pricing strategy, tax policy, revenue effect). This moves your answer from description to analysis.

Practice questions

  1. A 5% price rise leads to a 15% fall in quantity demanded. What is the PED and is demand elastic or inelastic?

    1. PED = −3, elastic
    2. PED = −0.33, inelastic
    3. PED = 3, elastic
    4. PED = 1, unit elastic

    (2 marks)

  2. Why do governments typically impose higher taxes on cigarettes and alcohol rather than food? Use elasticity to explain.

    (3 marks)

Summary

  • PED = %ΔQ / %ΔP. Negative (downward-sloping demand). $|PED| > 1$ elastic; $< 1$ inelastic.
  • Elastic: many substitutes, luxury, large income share, long run.
  • Inelastic: few substitutes, necessity, small income share, addictive.
  • TR rule: Elastic + price rise → TR falls. Inelastic + price rise → TR rises.
  • Government taxes on inelastic goods raise more revenue with less quantity reduction.

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