Command term: Discuss requires candidates to offer a considered and balanced review, including a range of arguments.

Responses should include the following:

A definition of price elasticity of demand. Candidates that defined PED in the first part of the response do not need to redefine this term, but must make reference to it in order to earn credit for the definition.

The response should contain relevant diagrams to illustrate goods with high / low PED elasticity.  For example, the first diagram represents a good with low PED elasticity and the second (below) a product with low PED elasticity.

In diagram 1, there is a rise in production costs, a result of a rise in one or more of the costs of production e.g. a rise in energy or labour costs, or a rise in interest rates making loan repayments more expensive.  In response the firm passes those additional costs on to the consumer, illustrated by a rise in price from P1 to P2. This in turn leads to a fall in quantity demanded falls from Q1 to Q2.  The firm ends up benefiting from the price rise, because the additional revenue gained from selling each unit more than compensates for the relatively small fall in quantity demanded.  The revenue gain is illustrated on diagram 1 by the orange shaded area, while the relatively small revenue loss is represented by the green rectangle.  

By contrast, diagram 2 illustrates a good or service with high PED elasticity.  Conscious of the low brand loyalty for this product, the seller is reluctant to increase their prices, but when forced, does so by a relatively small amount from P1 to P2.  This leads to a greater than proportional fall in quantity demanded and a loss of revenue, illustrated on the diagram by the green shaded area.  The gain in revenue is relatively small and is represented by the orange rectangle.

Lastly, a good or service with unitary PED elasticity, illustrated on the third diagram, will see no change in total revenue, following a rise in price, as the fall in quantity demanded will mirror exactly the rise in revenue per unit sold, making the firm indifferent to changes in price.

Responses should then discuss how this impacts on a firm's decision making process.  For example a firm producing PES elastic products would be very particularly reluctant to pass on the additional costs to the consumer, in the form of higher prices.  Instead the firm may choose to absorb the additional costs themselves or attempt to reduce other areas of the production costs, in order to avoid increasing prices.    

By contrast, firms producing PED inelastic goods would feel more confident about passing on the additional costs to the consumer and may even raise prices further than necessary.  An example of this might include the tobacco companies who continue to enjoy large profits despite significant rises in price as a result of indirect taxes placed on their production. 

Responses should then illustrate the impact of a fall in production costs on businesses producing goods and services with different levels of price elasticity.  For example a firm producing a PED elastic good, with a number of close substitutes, might be encouraged to engage in a price war.  This is illustrated in the final diagram, where a firm producing a PED elastic product has benefited from lowering prices, potentially at the expense of its competitors.

Firms producing PED inelastic goods and services will not benefit from a price war, but might instead look to collude with other competing firms e.g.  the oil companies.

Responses may conclude with a comparison of stakeholders, e.g. customers are more likely to benefit from PED products, while the producer will benefit most from the production of PED inelastic products, as well as a consideration of short run v long run elasticities.

Responses for section (b) should be graded according to the following mark bands:

Maximum mark for this section 15.