Explain why price elasticity of demand varies along the length of a straight-line demand curve.

Examine the significance of price elasticity of demand for the decision-making of firms and governments. 

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part A.

Answers may include:

• definitions of demand curve, price elasticity of demand
• diagram to show differing price elasticities of demand along a straight-line demand curve
• explanation why the price elasticity of demand varies along the length of the demand curve, using the diagram, the elasticity formula and an economic rationale (eg when the price is higher the proportion of income spent on the good is higher)
• examples (hypothetical numerical example to support the explanation or a hypothetical example of a single good or service sold at different prices and having different price elasticities of demand).

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part B.

Answers may include:

• definition of price elasticity of demand (PED)
• diagrams to show the relationship between PED, price changes and the total revenue of firms; the relationships between PED, the size of an indirect tax, tax incidence, quantity produced/consumed and government tax revenue
• explanations of the relationship between: PED, price changes and total revenue of firms; how PED affects government tax revenue, production/consumption and tax incidence
• examples of PED proving significant for firms and governments in practice
• synthesis and evaluation (examine).

Examination may include: the differing incidence of indirect tax on consumers and firms due to differing price elasticities, the impact of PED on the uses of tax/subsidy to address market failure, the impact of time on PED (and total revenue) when price changes, the difficulty of estimating PED values for firms, other factors affecting demand that cause a change in total revenue/tax revenue.

Award a maximum of level 2 if the response considers either the significance of PED for firms or for governments (but not both).

Examiners should be aware that candidates may take a different approach which, if appropriate, should be rewarded.

NB It should be noted that definitions, theory, and examples that have already been given in part (a), and then referred to in part (b) should be rewarded.

There were many candidates who were able to explain price elasticity of demand in principle but were not able to apply the economic theory to answer this particular question. A common mistake was to correctly explain why different products have different price elasticities of demand and/or to show the different elasticities on two separate diagrams. However, in this question part it is stated explicitly that elasticity “along… a straight-line demand curve” should be explored. Some candidates needlessly drew a supply curve on the diagram for this question and incorrectly assumed that at the intersection of the supply and demand curves the price elasticity of demand is necessarily equal to one. Some candidates were able to provide excellent numerical examples and/or technical (mathematical) explanations to demonstrate how the coefficient of the price elasticity of demand should vary along a straight-line demand curve but did not link the mathematical calculations to relevant economic theory.

The majority of the candidates seemed well prepared to answer this question. Still, there were some cases where the candidates were not careful enough and drew a market supply curve in addition to the market demand curve (implying a competitive market) while (correctly) explaining that a given (single) firm should set a price for its product at the point where price elasticity of demand is equal to one in order to maximize its total revenue. Given the specific demands of the question, such use of diagrams was not usually considered a significant error. However, such candidates could not get credit for clear understanding and application of relevant economic theory.