Using Price Elasticity of Demand (PED) (Cambridge International A-Level Economics)

PED and total expenditure/revenue

• Revenue is the amount of money a firm receives from selling its goods or services

  • Total revenue = price x quantity
  • Also referred to as consumer expenditure from the buyer’s perspective

• 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

The total revenue rule

1. Lowering price for elastic demand

• The demand curve is very elastic in this market

Price elastic demand where a small decrease in price from P1→P2 causes a large increase in revnue

Diagram analysis

• When a good or 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 from P₁to P₂

  • (P₂ x Q₂) > (P₁ x Q₁)

2. Raising price for inelastic demand

• The demand curve is very inelastic in this market

Price inelastic demand where a large increase in price from P1→P2 raises revnue

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

  • (P₂ x Q₂) > (P₁ x Q₁)

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 the firm has made the correct decision

Step 1: Calculate the initial sales revenue

Sales space Revenue space equals space Price space of space product space straight X space Quantity space sold space space space space space space space space space space space space space space space space space space space space space space space space space equals £ 10 space straight x space 100 space space space space space space space space space space space space space space space space space space space space space space space space space equals space £ 1 comma 000

Step 2: Calculate the sales revenue after the price change

Sales space Revenue space equals space Price space of space product space straight X space Quantity space sold space space space space space space space space space space space space space space space space space space space space space space space space space equals £ 15 space straight x space 40 space space space space space space space space space space space space space space space space space space space space space space space space space equals space £ 600

Step 3: Explain the decision

• By raising the price, total revenue has fallen by £400
• This indicates that the product is price elastic in demand
• The firm should have lowered their price in order to maximise revenue

Exam Hint 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 change than the increase in price.

When governments tax demerit goods such as cigarettes, the increase in price is greater than the decrease in QD, but QD still falls.

Using PED in decision-making

1. Strategic pricing decisions

• Businesses can use PED insights to guide pricing strategies:

  • If demand is inelastic, raising prices can boost revenue
  • If demand is elastic, lowering prices may increase sales volume and overall revenue

2. Making demand less sensitive to price

• Firms often aim to reduce price sensitivity to strengthen revenue potential. Strategies include:

  • Persuasive advertising: Highlighting unique benefits or endorsements to make products more appealing than alternatives
  • Branding: Creating a strong brand identity to differentiate from competitors and build customer loyalty
  • Mergers and acquisitions: Expanding market control by joining forces with competitors
  • Monopoly creation: Securing exclusive rights through patents or regulation to limit competition and control pricing

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

  • Sales revenue will be maximised

    • If their product is price inelastic in demand, they should raise their prices
    • If their product is price elastic in demand, then they should lower their prices
    • Firms lower their prices for elastic sections of their market, e.g., off-peak train travel
    • Firms increase prices for inelastic sections of their market, e.g., peak hour train travel

3. The implications of PED for governments

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

  • If governments tax price-inelastic 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