š° PED and Total Revenue
Why This Matters: Total revenue = Price Ć Quantity. When a firm changes its price, PED determines whether revenue goes UP or DOWN. This is one of the most practical applications of elasticity.
The rules
- Elastic demand (|PED| > 1): lower price ā TR RISES (the increase in Qd more than offsets the lower price)
- Elastic demand (|PED| > 1): raise price ā TR FALLS
- Inelastic demand (|PED| < 1): raise price ā TR RISES (the fall in Qd is small relative to the price increase)
- Inelastic demand (|PED| < 1): lower price ā TR FALLS
- Unit elastic (|PED| = 1): any price change ā TR UNCHANGED
Simple rule: with ELASTIC demand, go LOW on price. With INELASTIC demand, go HIGH on price. This is why cinemas charge high prices for popcorn (inelastic ā no alternatives inside) but run promotions on tickets (elastic ā many entertainment alternatives).
š¢ PED in the Real World
For businesses
- Pricing strategy ā set prices based on elasticity, not just costs
- Sales and discounts ā only effective for products with elastic demand
- Price discrimination ā charge different prices to groups with different PED
For governments
- Tax revenue ā taxing inelastic goods (cigarettes, petrol) generates more revenue because consumers keep buying
- Reducing consumption ā taxes only significantly reduce consumption of elastic goods
- Impact on producers ā with inelastic demand, producers can pass more of a tax on to consumers
Governments tax cigarettes heavily. Because demand is inelastic (addiction), the tax raises lots of revenue but does not dramatically cut smoking. This is a common exam evaluation point.
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āļø Showing Revenue Changes on Diagrams
Total revenue is shown as the rectangle formed by P Ć Q on a supply-demand diagram. When price changes, you compare the OLD rectangle with the NEW rectangle.
- Draw the original Pā Ć Qā rectangle (shaded one colour)
- Draw the new Pā Ć Qā rectangle (shaded another colour)
- If the new rectangle is BIGGER ā TR increased
- If the new rectangle is SMALLER ā TR decreased
For elastic demand: TR rectangles get BIGGER when price falls. For inelastic demand: TR rectangles get BIGGER when price rises. Visualise this to double-check your reasoning in the exam.