Edexcel IAL Economics: Rational choice, demand and elasticities (YEC11) – Revision Notes

These notes condense section 1.3.2 Consumer behaviour and demand, items 1 to 3, of the Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (YEC11), Issue 2, June 2018. The content belongs to Unit 1 (labelled IAS, and also part of the full IAL). For the reasoning behind each point, read the study guide, then try the practice questions. Also see the Unit 1 overview, the Edexcel economics hub, the printable checklist and free 10-minute diagnostics. All figures are invented, in invented currency units.

1. Rational choice (item 1)

• Assumption: consumers maximise utility; firms maximise profit.
• Six reasons consumers may not maximise utility, with a one-line cue each:

Reason	Cue
Herding	Copying the crowd, such as the longer queue
Habit	Same purchase repeated without thinking
Inertia	A better deal exists but switching feels like effort
Poor computational skills	Cannot compare value, such as price per 100 g
Need to feel valued	Pays for recognition or status, not just the product
Framing and bias	Same price, different wording (“surcharge” or “discount”)

• Evaluation line: the assumption is a useful first model; predictions hold on average but fail for rushed, complex or emotional decisions.

2. The demand curve (item 2)

• Demand = the amount buyers are willing and able to purchase across a range of prices over a period.
• Movement along: the result of a change in the good’s own price and nothing else.
• Shift: caused by anything else. Right = more at every price.
• Diminishing marginal utility: each extra unit adds less utility, so a consumer pays less for it, and the individual demand curve slopes down.

Shift factor	Effect on demand for good X
Price of a substitute rises	Shifts right
Price of a substitute falls	Shifts left
Price of a complement rises	Shifts left
Real income rises	Right for a normal good; left for an inferior good
Tastes move in favour	Right
Population grows, or the age mix suits the good	Right
Successful advertising	Right

Diminishing marginal utility, small example. Total utility for 1 to 4 cups of coffee is 24, 42, 54 and 60, so marginal utility is 24, 18, 12 and 6. If one util is worth 0.50, the buyer values the cups at 12, 9, 6 and 3. At a price of 6 the buyer takes 3 cups; at a price of 3, 4 cups. That is a downward-sloping demand curve built from falling marginal utility.

Method for any shift question: name the factor, say which way demand shifts, say what happens to quantity at the original price, then link to price and quantity in the market.

3. The three elasticities (item 3)

Measure	Formula	Sign tells you
PED	% change in quantity demanded / % change in own price	Usually negative
YED	% change in quantity demanded / % change in income	Positive = normal; negative = inferior
XED	% change in demand for good A, divided by % change in price of good B	Positive = substitutes; negative = complements

Percentage change = change / original value x 100.

Method: calculating any elasticity in four steps

1. Work out each percentage change as change / original x 100, keeping the sign.
2. Divide the numerator percentage by the denominator percentage.
3. Name the result (inelastic, inferior, substitutes and so on).
4. Say what it means for the firm, the buyers or the government in the case given.

PED values

Value	Name	Total revenue if price rises
0	Perfectly inelastic (vertical curve)	Rises in proportion
0 to -1	Inelastic	Rises
-1	Unitary	Unchanged
below -1	Elastic	Falls
minus infinity	Perfectly elastic (horizontal curve)	Falls to zero

Worked reminder. Price 1.20 to 1.32 is +10%. Quantity 900 to 855 is -5%. PED = -5 / 10 = -0.5, inelastic. Revenue rises from 900 x 1.20 = 1,080 to 855 x 1.32 = 1,128.60. A rise in revenue is what inelastic demand predicts.

Determinants of PED (five, as listed in the specification):

• More elastic when there are many substitutes, the good is a large share of spending or the good is durable.
• More inelastic when branding is strong or the good is addictive.

Straight-line demand curve (for example P = 80 - 4Q)

Price   Quantity   PED      Revenue
64      4          -4.0     256
40      10         -1.0     400
16      16         -0.25    256

The slope is the same all along the line, yet PED falls in size as price falls. Upper section elastic, midpoint unitary, lower section inelastic. Revenue peaks where PED is -1.

YED values

YED	Label
0	Perfectly income inelastic
0 to +1	Income inelastic (normal good)
above +1	Income elastic (normal good)
negative	Inferior good
infinite	Perfectly income elastic (theoretical)

XED values: strongly positive means close substitutes; near zero means unrelated; strongly negative means close complements.

Worked reminders for YED and XED. Incomes rise 5% and demand for foreign holidays rises 9%: YED = 9 / 5 = +1.8, income elastic. Demand for own-brand rice falls 2%: YED = -2 / 5 = -0.4, inferior. The price of bus tickets rises 10% and demand for taxis rises 4%: XED = +0.4, weak substitutes.

4. Who cares, and why (item 3j)

• Firms: PED guides pricing and revenue. YED forecasts sales as incomes grow. XED shows the effect of a rival’s price change or the knock-on to a complementary product.
• Consumers: those who buy inelastic essentials have little choice but to pay more after a price rise.
• Government: indirect taxes raise more revenue on inelastic goods but change behaviour less; elastic goods respond more but yield less. YED helps plan for services as incomes shift.
• Evaluation: elasticity changes with the price range and over time, and past estimates do not guarantee future responses.

Chain of reasoning for a pricing decision: PED is -0.5, so inelastic. A price rise of 10% cuts quantity by only 5%. Revenue rises. Costs fall slightly as fewer units are made, so profit is likely to rise. Evaluate: rivals may respond, elasticity may be higher at a bigger price rise, and some customers may leave for good.

Chain of reasoning for a government tax: PED is -0.4 for the taxed good. The tax raises the price. Quantity falls by less than the price rise in percentage terms. Tax revenue is large but consumption falls only a little. Evaluate: if the aim is to cut consumption, the tax may be too weak; if the aim is revenue, it may work well, though low-income households bear a larger share of their budgets.

Must-know distinctions

• Movement along a curve (own price) versus shift (other factors).
• Inelastic (the percentage response in quantity is smaller than the percentage change in price) versus steep (a straight line can look steep yet be elastic at its upper end).
• Normal good (YED above 0) versus inferior good (YED below 0).
• Substitutes (XED above 0) versus complements (XED below 0).

Quick self-test

1. State the rationality assumption for consumers and for firms.
2. Price rises from 5.00 to 5.50 and quantity falls from 200 to 160. Calculate PED and the new revenue.
3. Incomes rise 6% and demand rises 3%. Work out YED and say what type of good this is.
4. The price of good B rises 10% and demand for good A falls 4%. Calculate XED and state the relationship.
5. Does a fall in the good’s own price shift the demand curve?
6. PED is -0.6. Price rises 5%. By how much does quantity fall?
7. Total utility from the first three units is 30, 50 and 64. State marginal utility of each.
8. Give two factors that make demand more price inelastic.
9. What is PED at the midpoint of a straight-line demand curve?
10. Why does an inelastic good raise more indirect-tax revenue?

Answers

1. Consumers aim to maximise utility; firms aim to maximise profit.
2. %P = +10%, %Q = -20%, PED = -2.0 (elastic). Revenue = 160 x 5.50 = 880, down from 1,000.
3. YED = 3 / 6 = +0.5: normal, income inelastic.
4. XED = -4 / 10 = -0.4: complements, a weak link.
5. No. It is a movement along the curve.
6. 0.6 x 5 = 3%.
7. 30, 20, 14.
8. Strong branding and addictiveness (a lack of close substitutes is also correct).
9. -1, unitary.
10. Buyers cut back little after the tax raises the price, so more units remain to be taxed.

Where marks are usually lost

• Using the new value rather than the original in a percentage change.
• Quoting an elasticity without a conclusion such as “elastic” or “inferior”.
• Calling a price change a shift of the demand curve.
• Describing a steep straight line as inelastic throughout.
• Stating that total revenue rises without linking it to the PED value.
• Listing determinants without explaining the mechanism, such as why substitutes make switching easy.
• Treating the six reasons for non-rational choice as interchangeable, instead of linking each to a behaviour.
• Ending a significance answer with no judgement about how reliable elasticity estimates are.

Official syllabus

Source: Pearson Education Limited, Edexcel International Advanced Subsidiary/Advanced Level in Economics (specification, Issue 2, June 2018; first teaching September 2018), section 1.3.2 Consumer behaviour and demand, items 1 to 3.