(HL Economics series) Top 3 misconceptions in Topic 4: PED
Welcome back to our lost and found series where we cover the misconceptions that we as students faced and help them get back on the right track!
This week, we will be looking at PED, a topic that students find hard to explain but is actually not as bad as it looks.
1. What affects what?
In order to understand PED, we must first go back to the basics and remember that changes in price causes changes in quantity demanded. Some students get this wrong and think that when quantity demanded changes, price changes. (I suspect students think of this like a laymen whereby when there is less people wanting the good, price falls). Therefore it is important to remember that the factor is price changes and the effect is quantity demanded changes. (Also, please don’t confuse this for changes in demand- if you’re confused about this, check out our other article that explains the difference).
Now, how does this relate back to PED?
Let’s look at the definition of PED: The measure of responsiveness of the quantity of a good demanded to changes in its price. What this means in a simplified form is how much quantity demanded changes in response to changes in price. That means that price has to first change in order for us to measure how much quantity demanded changes because of that price change.
2. Does PED = the slope of the curve? Why does the PED vary along the curve?
As tempting as it is to say that the PED is the gradient of the curve, it is not. To understand why, we need to examine the formula of PED which is the (percentage change in quantity demanded)/(percentage change in price) .
Simplified, we get the following equation:
As you can see, the slope of the curve DOES NOT equal to the value of the PED, though it can be extremely useful in calculating the PED.
So, the next part is why the PED varies. That’s because of the second part of the simplified formula (above) which is (P/Q). Since the slope(gradient) is a constant and P/Q is changing along the curve (P/Q becomes smaller as price decreases and Quantity increases), therefore, the PED of the curve gets smaller and smaller towards the bottom of the curve.
3. Why does proportion of income spent on a good affect the PED?
This is one of the most confusing determinants of PED because of a single common misconception. Before we dive in to it, remember this: PED is concerned with percentages!
So, let’s take the example of a bottle of mineral water versus something super expensive like a sports car. Evidently, the cost of a bottle of mineral water will take up a small proportion of someone’s income, at least, relative to the sports car. Here’s the tricky part that students get confused.
With the same percentage increase in the prices of both items , we then compare how much quantity demanded changes in response to the price change.
What does this mean?
Let’s say the price of the sports car is $1,000,000 and the price of the bottle is $1. A 10% increase (same percentage increase) in both, would lead to the following results.
New price of sports car: $1,100,000
New price of bottle: $1.10
Now, which of the following price changes do you think consumers will feel the impact of more? A 10c increase or a $100,000 increase? Of course, the $100,000! This means that even though both items faced a 10% increase in price, the percentage change in quantity demanded of the higher-priced item (the sports car in this case) would be much higher.
We hope this has helped you understand some of the common pitfalls students like yourself might have. If you know someone who doesn’t listen in Economics class, it might be worthwhile to send this resource to him/her. You might save him/her from a catastrophe. Then he might owe you a meal.
Win-win?
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