The Significance of PED (Cambridge International IGCSE Economics)

PED and Total Revenue

Spec point — The relationship between PED and total spending on a product/revenue, both in a diagram and as a calculation.

• 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

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

• 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

  • $(P_{2}\times Q_{2})>(P_{1}\times Q_{1})$

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

• 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

  • $(P_{2}\times Q_{2})>(P_{1}\times Q_{1})$

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

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, 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

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 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

Spec point — The implications for decision making by consumers, producers and government.

• 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