Pearson Edexcel International Advanced Level Economics: Rational choice, demand and elasticities (YEC11)

This guide covers 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 sits in Unit 1, which the specification labels IAS (International Advanced Subsidiary) and which also counts towards the full IAL. All numbers below are made up for illustration, and money amounts are in invented currency units.

Related pages: revision notes, practice questions, Unit 1 overview, the Edexcel economics hub, the printable checklist and free 10-minute diagnostics.

What the specification asks for

Item	You must be able to
1a, 1b	Explain the rationality assumption and six reasons consumers may not maximise utility
2a to 2d	Define demand, separate movements from shifts, use diminishing marginal utility, list shift factors
3a to 3d	Define and calculate PED, YED and XED; interpret PED values; explain what determines PED
3e to 3g	Calculate total revenue; PED along a straight-line demand curve; PED and total revenue
3h, 3i	Interpret YED (normal and inferior goods) and XED (substitutes, complements, unrelated)
3j	Judge why the three elasticities matter to firms, consumers and government

1. Rational decision making

Rationality (1a): consumers aim to maximise utility (satisfaction) from limited income, and firms aim to maximise profit. The assumption lets economists predict behaviour: if the price of a good falls, a utility maximiser buys more.

Why consumers may not maximise utility (1b):

• Herding: copying others. People queue at the busier of two similar cafés because the crowd seems to signal quality, even if the quiet café suits them better.
• Habit: repeating a purchase without reconsidering it, such as buying the same brand of tea each week.
• Inertia: staying put because change takes effort. A household pays 60 a month on a default broadband tariff when a 48 deal exists. The saving is 12 x 12 = 144 a year, or 20% of the bill, yet switching “takes two hours”, so nothing happens.
• Poor computational skills: misjudging value. Pack A is 400 g for 2.80 and pack B is 650 g for 4.29. Per 100 g, A costs 0.70 and B costs 0.66. A shopper who guesses by eye may pick A.
• Need to feel valued: paying more for status, attention or recognition, for example a tailor who knows your name, rather than for the product alone.
• Framing and bias: the same facts presented differently change choices. A shop charges 100 for cash or 105 by card. Called a “5 card surcharge”, it feels like a loss. Called a “5 cash discount”, it feels like a gain, though the prices are identical.

Evaluation: these behaviours mean a demand curve is a prediction, not a law. Predictions still tend to hold on average because most buyers do respond to price. The rationality assumption is a useful starting point that needs qualifying when decisions are rushed, complex or emotional.

2. The demand curve

Demand (2a) is the amount of a good that buyers are both willing and able to purchase at each possible price over a stated period, other things equal. Willingness without ability (income) is not demand.

Movement or shift (2b):

• A move in the good’s own price alone gives a movement along the existing curve (a price rise contracts quantity demanded; a fall extends it).
• A change in any other influence shifts the whole curve. A rightward shift means more is demanded at every price.

Diminishing marginal utility (2c): each extra unit consumed in a period adds less satisfaction than the one before. Suppose slices of pizza at one sitting give total utility of 20, 36, 48, 56 and 60 utils.

Slices	Total utility	Marginal utility	Money value of marginal utility (1 util = 0.50)
1	20	20	10
2	36	16	8
3	48	12	6
4	56	8	4
5	60	4	2

A rational consumer buys another slice only while the money value of its marginal utility is at least the price. At a price of 8 the consumer buys 2 slices, at 6 buys 3, at 4 buys 4 and at 2 buys 5. Because marginal utility falls, a lower price is needed to tempt the consumer to buy more, so the individual demand curve slopes downward.

Shift factors (2d), each with a chain of reasoning:

• Price of a substitute falls: buyers switch away, so demand for this good shifts left. If a streaming service cuts its price, weekly cinema demand might fall from 1,000 to 850 tickets at a price of 10, a 15% fall.
• Price of a complement rises: the pair becomes costlier, so demand for the other good shifts left.
• Real income rises (income adjusted for price changes): demand for a normal good shifts right; for an inferior good it shifts left.
• Tastes: a fashion or health trend shifts demand towards or away from a good.
• Population size and age distribution: an ageing population shifts demand right for healthcare and left for school supplies.
• Advertising: persuades and informs buyers, shifting demand right if effective.

3. Price, income and cross elasticities

Price elasticity of demand (PED) shows how strongly quantity demanded reacts when the good’s price changes (3a).

PED = % change in quantity demanded / % change in price

The same pattern gives YED (% change in quantity demanded / % change in income) and XED (the % change in demand for good A over the % change in the price of good B) (3b). Percentage change = change / original x 100.

Worked example (PED). A florist raises the price of a bouquet from 12.00 to 13.20; weekly sales fall from 80 to 68.

• % change in price = 1.20 / 12.00 x 100 = +10%.
• % change in quantity = -12 / 80 x 100 = -15%.
• PED = -15 / +10 = -1.5.

Because price and quantity move in opposite directions, PED for a normal demand curve is negative. Read its size: here 1.5.

Interpreting PED (3c):

PED value	Description	Curve
0	Perfectly price inelastic	Vertical
between 0 and -1	Price inelastic	Steep
-1	Unitary price elastic	Rectangular hyperbola
below -1, such as -3	Price elastic	Flat
minus infinity	Perfectly price elastic	Horizontal

Determinants of PED (3d), each with its reasoning:

• Availability of substitutes: many close substitutes make it easy to switch, so demand is more elastic.
• Branding: strong loyalty reduces willingness to switch, so demand is less elastic.
• Percentage of total expenditure: a tiny share of income, such as salt, barely prompts a change; a large share, such as a car, makes buyers sensitive to price.
• Addictiveness: dependent users keep buying, so demand is more inelastic.
• Durability: a durable good can be repaired or its replacement postponed, so demand is more elastic.

Total revenue (3e) = price x quantity demanded. For the florist, revenue was 80 x 12.00 = 960 and becomes 68 x 13.20 = 897.60, a fall of 62.40 (6.5%).

PED and total revenue (3g):

Price change	If demand is elastic	If unitary	If inelastic
Price rises	total revenue drops	stays level	total revenue climbs
Price falls	total revenue climbs	stays level	total revenue drops

Inelastic case: a fuel station raises its price from 1.50 to 1.65 (+10%). Sales fall from 8,000 to 7,600 litres (-5%). PED = -5 / 10 = -0.5. Revenue rises from 12,000 to 12,540. Now an elastic case: a price cut from 20 to 18 (-10%) lifts sales from 400 to 520 (+30%), giving PED = -3 and revenue from 8,000 to 9,360.

PED along a straight-line demand curve (3f). Take the invented demand curve P = 100 - 2Q. Slope is constant, but PED is not, because the ratio P/Q changes.

Price	Quantity	PED	Total revenue
90	5	-9.0	450
70	15	-2.33	1,050
50	25	-1.0	1,250
30	35	-0.43	1,050
10	45	-0.11	450

Each PED is found as % change in quantity over % change in price for a move away from that point along the line. From 90 to 80, quantity rises from 5 to 10 (+100%) and price falls 11.1%, so PED = -9. Described in words: the upper half of the line is elastic, the midpoint is unitary and the lower half is inelastic. Revenue is highest at the midpoint, where PED is -1.

Price
 100 +
     |\  elastic: PED below -1
  50 | \ unitary at the midpoint
     |  \ inelastic: PED between 0 and -1
   0 +---\--- Quantity (0 to 50)

Income elasticity of demand (3h). Real incomes rise 5% (from 30,000 to 31,500). Gym memberships rise from 1,000 to 1,070 (+7%), so YED = 7 / 5 = +1.4. Bus trips fall from 5,000 to 4,900 (-2%), so YED = -2 / 5 = -0.4.

YED	Meaning
0	Perfectly income inelastic: demand ignores income
between 0 and +1	Income inelastic: a necessity-type normal good
above +1	Income elastic: a luxury-type normal good
infinite	Perfectly income elastic: only a theoretical limit
negative	Inferior good: demand falls as income rises

Cross elasticity of demand (3i). If tea bags rise from 2.50 to 2.70 (+8%) and coffee demand rises from 500 to 560 jars (+12%), XED = 12 / 8 = +1.5: substitutes. If printer prices rise 5% and ink cartridge demand falls 3%, XED = -0.6: complements. A value close to zero suggests the goods are unrelated. The larger the positive value, the closer the substitutes; the larger the negative value, the stronger the complementarity.

Significance (3j):

• Firms use PED to set prices (raise price if inelastic, cut it if elastic), YED to forecast. If incomes grow 3% a year and YED is +2.0, expected demand rises 6%, so 50,000 units become 53,000. A rival’s 5% price rise with XED of +2.0 lifts the firm’s demand by 10%.
• Consumers on low incomes spending on inelastic necessities have little room to avoid price rises.
• Governments use PED to forecast the effect of indirect taxes. A 0.50 tax on a good at 5.00 (+10%) with PED of -0.4 cuts sales by 4%, from 100,000 to 96,000, raising 48,000. With PED of -2, sales fall 20% to 80,000 and revenue is 40,000, but consumption falls much further. YED helps planning of services as incomes change.

Limits: elasticity estimates rely on past data, hold only for a price range and ignore other changes in the market.

Common errors

• Calling a change in the good’s price a “shift”. It is a movement.
• Dividing the change by the new figure instead of the original.
• Giving one elasticity for a whole straight-line demand curve. It changes along the line.
• Dropping the sign and then misreading an inferior good or complement.
• Giving only the revenue effect and not the reason (the PED value).

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.