The Significance of PED (DP IB Economics)
Revision Note
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
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
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
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
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Availability of substitutes |
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Price of product as a proportion of income |
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Luxury or necessity |
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Addictiveness of the product |
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Time period |
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