Price elasticity of demand and total revenue

Last time

Before we start: last time, in Equilibrium, the price mechanism and consumer and producer surplus, you learned these points. Here they are again on one card. Keep them in mind, because today builds on them.

Measuring responsiveness

Firms and governments need to know not just that demand falls when price rises, but by how much. Price elasticity of demand measures it. This lesson covers the formula, the values, the determinants, and the vital link to total revenue.

The formula

PED is the percentage change in quantity demanded divided by the percentage change in price. If price rises by 4 per cent and quantity demanded falls by 6 per cent, PED is minus 6 over 4: minus 1.5, price elastic. PED is usually negative, so economists often discuss its absolute size.

PED values

The values of PED, by size.

Determinants

Availability and closeness of substitutes: more and closer substitutes make demand more elastic. Proportion of income spent: a large share makes demand more elastic. Necessity or luxury: necessities are inelastic. Time: demand becomes more elastic over time. Habit and addiction make it inelastic. And how widely the product is defined.

Total revenue and PED

Total revenue, or total expenditure by consumers, is price times quantity. If demand is price inelastic, a price rise increases total revenue; a price cut reduces it. If demand is price elastic, a price rise reduces total revenue; a price cut increases it. At unitary elasticity, revenue is unchanged.

Revenue, worked

A firm selling 100 units at 10 dollars earns 1,000 dollars. At 12 dollars: with inelastic demand it sells 95, earning 1,140; with elastic demand it sells 70, earning 840.

Uses of PED

Firms use PED to set prices and predict revenue, and for price discrimination: charging more where demand is inelastic. Governments use it to choose what to tax: inelastic goods raise revenue reliably; to reduce consumption, a tax works better on elastic goods. It also predicts how an exchange rate change affects export revenue.

Limitations of PED

PED estimates are based on past data and assume other things are equal, which rarely holds. PED changes along a straight-line demand curve and over time, so one figure can mislead. So a firm should use PED as a guide, alongside its knowledge of the market.

Elastic or inelastic?

To judge a product's PED, apply each determinant: its substitutes, share of income, necessity and habit. For example, petrol has few close substitutes and is a necessity for many, so is inelastic in the short run. But over time people buy efficient cars, so demand becomes more elastic.

Mistakes that lose marks

Mistake one: putting price on top of the formula. Mistake two: assuming a price rise always raises revenue. Mistake three: listing determinants without applying them to the product in the question. The fix: formula right, revenue linked to PED, determinants applied.

The full-marks tip

The full-marks tip: link PED to total revenue every time a price change is discussed. Apply determinants to the product, then evaluate the limits of PED.

On one card

So, on one card: price elasticity of demand. Keep it for revision.