PED, Consumer Expenditure and Firms’ Revenue (Cambridge International IGCSE Economics)

PED and total revenue

Spec point — "• effect of price changes on the amount spent by consumers and revenue raised by firms, shown both in a diagram and as a calculation • relationship between PED and the amount spent by consumers and revenue raised by firms"

PED and total 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

Illustrating the gains using a demand curve

Lowering price for elastic demand

• This can be illustrated using a demand curve
• 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

• 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)

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

• 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.