Cambridge IGCSE0455

Price changes

Economics 0455 Chapter Notes

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Price changes - Causes of price changesPrice changes - Consequences of price changes
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In this chapter

  1. 1Measuring Price Changes: The CPI
  2. 2Price Elasticity of Demand (PED)
  3. 3PED and Total Revenue Strategy
  4. 4Factors Determining Price
  5. 5Exchange Rates and International Prices

1. Measuring Price Changes: The CPI

Inflation is a sustained increase in the general price level of goods and services in an economy over a period of time, leading to a fall in the purchasing power of money. The most common measure of inflation is the Consumer Price Index (CPI). The CPI tracks the price of a 'shopping basket' of goods and services bought by a typical household. Because households spend more on some items than others (e.g., more on housing than on salt), items in the basket are 'weighted' according to their importance in average household expenditure. To calculate the CPI, a base year is chosen and given an index value of 100. In subsequent years, the weighted average price of the basket is compared to the base year to calculate the new CPI value. The percentage change in the CPI from one year to the next gives the rate of inflation.

Weighted Price = Σ (Price of item × Weight of item)

CPI = (Weighted average price in current year / Weighted average price in base year) × 100

Inflation Rate (%) = ((CPI in Year 2 - CPI in Year 1) / CPI in Year 1) × 100

Key term

Consumer Price Index (CPI): An index number that measures the average change in prices paid by consumers for a representative basket of goods and services.

Examiner insight

Examiners reward students who can explain why the CPI basket and its weights must be updated, linking this to new technology, changing tastes, and quality improvements.

Common pitfall

Confusing the CPI index level (e.g., 151.2) with the rate of inflation. The index is a point-in-time measure relative to a base year, while inflation is the rate of change between two index levels.

Worked example 16 marks

Using the data below, and assuming a base year weighted average price of $25, calculate:a) The weighted average price for Year 3 and Year 4.b) The CPI for Year 3 and Year 4.

  1. 1

    a) First, calculate the weighted average price for each year by multiplying the price of each category by its weight (proportion of expenditure) and summing the results.

  2. 2

    Weighted Price (Year 3) = ($50 × 0.25) + ($100 × 0.15) + ($9 × 0.45) + ($22 × 0.15) = $12.50 + $15.00 + $4.05 + $3.30 = $34.85

  3. 3

    Weighted Price (Year 4) = ($55 × 0.26) + ($110 × 0.14) + ($10 × 0.46) + ($25 × 0.14) = $14.30 + $15.40 + $4.60 + $3.50 = $37.80

  4. 4

    b) Now, calculate the CPI for each year using the formula: CPI = (Weighted average price / Base year price) × 100.

  5. 5

    CPI (Year 3) = ($34.85 / $25) × 100 = 139.4

  6. 6

    CPI (Year 4) = ($37.80 / $25) × 100 = 151.2

Recap

  • The CPI measures the change in the cost of a weighted basket of consumer goods and services.
  • Weights reflect the proportion of household income spent on different categories.
  • A base year is used as a benchmark, with a CPI value of 100.
  • The inflation rate is the percentage change in the CPI over a period, usually a year.
  • The basket and weights are updated periodically to reflect changing consumption patterns.

Quick check

  1. If the CPI was 120 last year and is 126 this year, what is the annual inflation rate?2 marks
  2. Why are goods in the CPI basket 'weighted'?1 mark

2. Price Elasticity of Demand (PED)

Price Elasticity of Demand (PED) measures how much the quantity demanded of a good responds to a change in its own price. It answers the question: 'If I change the price, by how much will demand change?' The result is a number. If the PED value is greater than 1, demand is 'price elastic' – quantity demanded is very responsive to price changes. If the value is less than 1, demand is 'price inelastic' – quantity demanded is not very responsive. If the value is exactly 1, it is 'unitary elastic'. Note that the PED value is technically always negative because price and quantity demanded move in opposite directions, but economists usually ignore the minus sign and focus on the absolute value.

PED = (% Change in Quantity Demanded) / (% Change in Price)

% Change in Quantity Demanded = ((New Quantity - Original Quantity) / Original Quantity) × 100

% Change in Price = ((New Price - Original Price) / Original Price) × 100

Key term

Price Elasticity of Demand (PED): A measure of the responsiveness of the quantity demanded of a good to a change in its price.

Common pitfall

Calculating percentage changes using the new price or quantity as the denominator instead of the original values. Always divide by the original number.

Fun fact

The demand for life-saving medicines is almost perfectly inelastic. No matter how much the price increases, people who need the medicine will still try to buy it, so the quantity demanded changes very little.

Worked example 14 marks

The price of a chocolate bar increases from $2.00 to $2.50. As a result, weekly demand falls from 1,000 bars to 800 bars. Calculate the PED and state whether demand is price elastic or inelastic.

  1. 1

    Step 1: Calculate the percentage change in price.

  2. 2

    % Change in Price = (($2.50 - $2.00) / $2.00) × 100 = ($0.50 / $2.00) × 100 = 25%

  3. 3

    Step 2: Calculate the percentage change in quantity demanded.

  4. 4

    % Change in Quantity Demanded = ((800 - 1,000) / 1,000) × 100 = (-200 / 1,000) × 100 = -20%

  5. 5

    Step 3: Calculate PED.

  6. 6

    PED = (% Change in Qd) / (% Change in P) = -20% / 25% = -0.8

  7. 7

    Step 4: Interpret the result. The PED value is 0.8 (ignoring the minus sign). Since 0.8 is less than 1, demand is price inelastic.

Recap

  • PED measures the responsiveness of demand to a price change.
  • If PED > 1, demand is price elastic.
  • If PED < 1, demand is price inelastic.
  • If PED = 1, demand is unitary elastic.
  • The formula for PED is the percentage change in quantity demanded divided by the percentage change in price.
  • Necessities tend to have inelastic demand, while luxuries tend to have elastic demand.

Quick check

  1. If a 10% rise in price causes a 20% fall in quantity demanded, what is the PED?1 mark

3. PED and Total Revenue Strategy

Understanding PED is vital for businesses because it allows them to predict how a price change will affect their total revenue. Total revenue is the total income from sales, calculated as Price × Quantity sold. The link is simple but powerful: If demand is price elastic (PED > 1), a price fall will lead to a proportionally larger increase in quantity demanded, causing total revenue to rise. Conversely, a price rise will cause total revenue to fall. If demand is price inelastic (PED < 1), a price rise will lead to a proportionally smaller decrease in quantity demanded, causing total revenue to rise. A price fall will cause total revenue to fall. Therefore, a firm with an inelastic product should consider raising its price to boost revenue, while a firm with an elastic product should consider lowering it.

Total Revenue = Price × Quantity

Key term

Total Revenue: The total amount of money a firm receives from selling its goods or services, calculated as the price per unit multiplied by the quantity of units sold.

Examiner insight

Examiners look for a clear, logical chain of reasoning: state the PED, explain the implication for quantity demanded following a price change, and then explicitly link this to the final effect on total revenue.

Worked example 15 marks

An airline reduces the price of a ticket from $500 to $400. As a result, the number of tickets sold per month increases from 1,000 to 1,800.a) Calculate the PED for these airline tickets.b) Calculate the total revenue before and after the price change.c) Advise the airline if this was a good decision.

  1. 1

    a) % Change in Price = (($400 - $500) / $500) × 100 = -20%. % Change in Quantity Demanded = ((1,800 - 1,000) / 1,000) × 100 = +80%. PED = 80% / -20% = -4. The PED is 4, which is price elastic.

  2. 2

    b) Original Total Revenue = $500 × 1,000 = $500,000.

  3. 3

    New Total Revenue = $400 × 1,800 = $720,000.

  4. 4

    c) This was an excellent decision. Because demand for the tickets is price elastic (PED > 1), the percentage increase in quantity demanded was far greater than the percentage decrease in price. This led to a significant increase in total revenue of $220,000.

Recap

  • Total Revenue is calculated as Price multiplied by Quantity sold.
  • If demand is price elastic (PED > 1), price and total revenue move in opposite directions.
  • If demand is price inelastic (PED < 1), price and total revenue move in the same direction.
  • If demand is unitary elastic (PED = 1), a price change leaves total revenue unchanged.
  • Firms can use knowledge of PED to inform their pricing strategies to maximise revenue.

Quick check

  1. A coffee shop sells a product with a PED of 0.6. Should it increase or decrease its price to raise total revenue?1 mark

4. Factors Determining Price

Setting the price of a product is a complex decision influenced by several key factors. No single factor works in isolation. 1) Costs of Production: At a minimum, the price must cover all costs (fixed and variable) in the long run for the firm to be profitable. 2) Business Objectives: A firm aiming to maximise profit might set a high price, while a firm aiming to gain market share might set a low price to attract customers from rivals. 3) Competition (Market Structure): In a highly competitive market, firms have little pricing power and may have to accept the going market price. A monopoly with no competition has significant freedom to set its own price. 4) Consumer Demand: Firms must consider what customers are willing to pay. This is where PED is crucial; it helps a firm understand how demand will react to the price it sets. 5) Government Regulation: Governments can influence prices through taxes (like VAT) which increase the final price, or subsidies, which can allow firms to lower their prices.

Key term

Price Skimming: A pricing strategy where a firm charges a high initial price for a new product, often to recoup development costs, before lowering the price over time as competition enters.

Examiner insight

High-scoring answers discuss the interaction between these factors, for example, how a firm's objective to maximise profit might be limited by fierce competition from rival firms.

Common pitfall

Assuming that firms set prices simply by adding a profit margin to their costs. This ignores the crucial roles of consumer demand and competition.

Worked example 14 marks

A car manufacturer is deciding the price for its new electric model. Its main objective is to establish a reputation as a market leader. The market has several other established competitors. Explain how these two factors (business objective and competition) will influence its pricing decision.

  1. 1

    Factor 1 (Business Objective): The objective is to be a market leader, not necessarily to maximise short-term profit. This suggests the firm should not set the highest possible price. A competitive price is needed to attract a high volume of sales and build market share.

  2. 2

    Factor 2 (Competition): The presence of 'several other established competitors' means the firm is not a monopoly. It must be price-competitive. If it sets its price too high relative to rivals' cars with similar features, consumers will simply buy from the competition.

  3. 3

    Conclusion: Given the objective to be a market leader and the presence of competition, the firm should adopt a strategy of competitive pricing. The price should be set close to the prices of its main rivals, while perhaps highlighting superior features to justify a small premium. A very high price would be unsuitable.

Recap

  • A firm's price must cover its costs of production in the long run.
  • The level of competition in a market heavily constrains a firm's pricing power.
  • Pricing strategy depends on business objectives, such as profit maximisation or gaining market share.
  • Firms must consider consumer demand and willingness to pay.
  • Government taxes increase prices, while subsidies can lower them.

Quick check

  1. Name two factors, other than its own costs, that a firm must consider when setting a price.2 marks

5. Exchange Rates and International Prices

An exchange rate is the price of one currency in terms of another (e.g., £1 = $1.25). When a currency 'appreciates' or gets stronger, it can buy more of another currency. When it 'depreciates' or gets weaker, it can buy less. These changes directly affect the prices of exports and imports. A useful mnemonic is SPICED: Stronger Pound makes Imports Cheaper and Exports Dearer. If the pound appreciates, it costs UK firms less to buy goods from abroad (cheaper imports), but for American customers, UK goods become more expensive (dearer exports). The opposite is also true. A weaker pound makes imports more expensive for UK consumers but makes UK exports cheaper and more competitive for foreign buyers. The ultimate impact on a firm's revenue depends on the PED for its exports.

Key term

Exchange Rate: The price of one country's currency expressed in terms of another country's currency.

Examiner insight

Top marks are awarded for tracing the full chain of events: exchange rate change → impact on export/import price → change in quantity demanded (linking to PED) → final impact on revenue or expenditure.

Common pitfall

Confusing the effect of an appreciation/depreciation. Remember SPICED: Stronger Pound, Imports Cheaper, Exports Dearer.

Worked example 15 marks

A Thai company exports coats to France, priced at 4,000 Thai Baht (THB). The initial exchange rate is 1 euro = 40 THB. The euro then depreciates, so the new rate is 1 euro = 32 THB.a) Calculate the price of the coat in euros at both exchange rates.b) If demand for these coats in France is price elastic, what will happen to the Thai firm's revenue (measured in euros) after the change?

  1. 1

    a) First, calculate the original price in euros.

  2. 2

    Original Price = 4,000 THB / (40 THB per euro) = 100 euros.

  3. 3

    Next, calculate the new price after the euro depreciation.

  4. 4

    New Price = 4,000 THB / (32 THB per euro) = 125 euros.

  5. 5

    b) The price of the coat for French consumers has increased from 100 to 125 euros. The question states that demand is price elastic. For an elastic good, a price increase leads to a proportionally larger decrease in quantity demanded.

  6. 6

    Therefore, the Thai firm's total revenue measured in euros will fall.

Recap

  • Appreciation means a currency gets stronger; it can buy more of a foreign currency.
  • Depreciation means a currency gets weaker; it can buy less of a foreign currency.
  • A stronger domestic currency makes imports cheaper and exports more expensive.
  • A weaker domestic currency makes imports more expensive and exports cheaper.
  • The effect of an exchange rate change on export revenue depends on the PED for those exports.

Quick check

  1. If the US dollar depreciates against the Japanese yen, will Japanese cars become more or less expensive for American buyers?1 mark

End-of-chapter exercise

Test yourself on the whole chapter. Work through these before moving on.

  1. Define Price Elasticity of Demand (PED).2 marks
  2. A product's price rises from $10 to $12, and weekly demand falls from 200 to 190 units. Calculate the PED.3 marks
  3. Explain, using the concept of PED, why a government might choose to place a high tax on cigarettes but not on fresh fruit.4 marks
  4. A firm discovers the PED for its product is 0.4. Explain what this value means and advise the firm on how to increase its total revenue.5 marks
  5. The price of oil, a key raw material for plastics, increases significantly. Using a demand and supply diagram, analyse the likely impact on the equilibrium price and quantity of plastic chairs.6 marks
  6. A UK company exports cars to the USA. The exchange rate changes from £1 = $1.20 to £1 = $1.50. Explain the effect on the price of the cars in the USA and discuss the likely impact on the UK company's total revenue, making reference to PED.6 marks
  7. A household's spending is 60% on food (which has a price index of 120) and 40% on housing (which has a price index of 110). Calculate the household's personal weighted inflation index.4 marks
  8. 'A business should always set the highest price the market will bear.' Discuss this statement, considering factors that influence a firm's pricing decisions.8 marks
  9. Explain two reasons why the basket of goods used to calculate the Consumer Price Index (CPI) must be updated regularly.4 marks
  10. A firm launches a new video game. In the first month, it uses a price skimming strategy. After six months, it lowers the price significantly. Explain the economic rationale behind this two-stage pricing strategy, referring to competition and consumer demand.7 marks

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