IBEconomicsDPSLRevision Notes2. Microeconomics2.4 Price Elasticity of Demand (PED)The Significance of PED

The Significance of PED (DP IB Economics): Revision Note

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DP Economics: SLDP Economics: HL

PED & Total Revenue

  • The total revenue rule states that in order to maximise revenue, firms should increase the price of products that are price inelastic in demand and decrease prices on products that are elastic in demand 

  • The benefits of this rule can be illustrated using a demand curve

    • A shallow curve represents a price-elastic product

    • A steep curve represents a price inelastic product

3-3-1-elastic-ar_edexcel-al-economics

An illustration of price elastic demand where a small decrease in price from P1→P2 causes a large increase in quantity demanded from Q1→ Q2

 
Diagram Analysis

  • When a good/service is price elastic in demand, there is a greater than proportional increase in the quantity demanded to a decrease in price

  • A small decrease in price leads to a larger increase in QD

  • TR is higher once the price has been decreased

    • left parenthesis straight P subscript 2 cross times straight Q subscript 2 right parenthesis space greater than space left parenthesis straight P subscript 1 cross times straight Q subscript 1 right parenthesis

3-3-1-inelastic-ar_edexcel-al-economics

An illustration of price inelastic demand where a large increase in price from P1→P2 causes a small decrease in quantity demanded from Q1→ Q2

Diagram Analysis

  • When a good/service is price inelastic in demand, there is a smaller than proportional decrease in the quantity demanded to an increase in price

  • A large increase in price leads to a smaller decrease in QD

  • TR is higher once the price has been increased

    • left parenthesis straight P subscript 2 cross times straight Q subscript 2 right parenthesis space greater than space left parenthesis straight P subscript 1 cross times straight Q subscript 1 right parenthesis

The Implications of PED for Firms & Governments

  • Knowledge of PED is important to firms seeking to maximise their revenue

    • If their product is price inelastic in demand, they should raise their prices

    • If price elastic in demand, then they should lower their prices

    • Firms can choose to use price discrimination to maximise their revenue i.e. lower prices for certain segments and higher prices for others

  • Knowledge of PED is important to Governments with regard to taxation and subsidies

    • If governments tax price inelastic in-demand products, they can raise tax revenue without harming firms too much

      • Consumers are less responsive to price changes so firms will pass on the tax to the consumer

    • If Governments subsidise price elastic in demand products, there can be a greater than proportional increase in the quantity demanded

      • This strategy is especially good for encouraging consumption of merit goods such as electric vehicles

The PED of Primary Commodities & Manufactured Products

  • The PED of primary commodities (agricultural products or raw materials) tends to be lower than that of manufactured products (washing machines, phones, cars etc) for several reasons

  • The best way to explain the reasons for the differences is to apply the factors that determine the price elasticity of demand ( see sub-topic 2.5.1)

    • These can be summarised using the acronym SPLAT

      • Substitutes

      • Proportion of income

      • Luxury or necessity

      • Addictiveness

      • Time period

 

A Comparison of the PED of Primary Commodities & Manufactured Products


PED Factor


Primary Commodities - Inelastic
(PED = 0-1)


Manufactured Goods - Elastic
(PED = >1)

Availability of substitutes

  • Few substitutes as the required raw materials are defined by the product design

  • Usually many substitutes e.g. different types of smart phones

Price of product as a proportion of income

  • Each raw material component tends to be a fraction of the overall cost of the product which means demand if inelastic

  • Demand for manufactured goods such as cars or washing machines tend to take a larger proportion of the consumers income which makes the PED more elastic

 Luxury or necessity

  • Commodities are necessities as they are raw materials used in the production of goods

  • Many manufactured goods tend to be luxuries e.g Swiss watches

Addictiveness of the product

  • Certain raw materials are highly sought after by manufacturers e.g. iridium is a rare earth metal used to help create the famous Apple Macbook shell

  • Some manufactured goods can be very addictive e.g. cigarette's

  • However, the availability of substitutes makes them less inelastic than they otherwise would be

Time period

  • The time period to grow or extract primary commodities is much longer than that required to manufacture products

  • Many products are manufactured in a relatively short time period

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