The Significance of PED (Cambridge (CIE) O Level Economics)
Revision Note
PED and Total Revenue
Revenue is the amount of money a firm receives from selling its goods/services
Total revenue = price x quantity
The total revenue rule states that in order to maximise revenue, firms should increase the price of products that are inelastic in demand and decrease prices on products that are elastic in demand
This can be illustrated using a demand curve
Diagram analysis
The demand curve is very elastic in this market
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
Total revenue is higher once the price has been decreased
Diagram analysis
The demand curve is very inelastic in this market
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
Total revenue is higher once the price has been increased
Worked Example
A firm raises the price of its products from £10 to £15. Sales have fallen from 100 to 40 units per day. Explain if they made the correct decision
Step 1: Calculate the initial sales revenue
Step 2: Calculate the sales revenue after the price change
Step 3: Explain the decision
By raising the price, the total revenue has fallen by £400. This indicates that the product is price elastic in demand and the firm should have lowered their price in order to maximise revenue
Examiner Tip
A common error students make is to say that when prices increase and the product is inelastic in demand, the quantity demanded does not fall. It does! But it is a less than proportional fall than the increase in price.
So, when Governments tax demerit goods such as cigarettes, the increase in price is greater than the decrease in QD, but QD still falls.
The Implications of PED for Stakeholders
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 they 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 demand
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