Relationship between PED and the amount spent by consumers and revenue raised by firms

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Price Elasticity of Demand (PED)

Introduction

Price elasticity of demand (PED) is a measure of how much the quantity demanded of a good or service changes in response to a change in its price. It is a crucial concept in economics as it helps businesses understand how their sales will be affected by price fluctuations and how consumers react to changes in price. Understanding PED is vital for firms when making pricing decisions and for governments when considering taxation policies.

Calculating PED

PED is calculated using the following formula:

$$PED = \frac{\text{Percentage change in quantity demanded}}{\text{Percentage change in price}}$$

The percentage change in quantity demanded is calculated as: $$ \frac{\text{New Quantity} - \text{Old Quantity}}{\text{Old Quantity}} \times 100$$

The percentage change in price is calculated as: $$ \frac{\text{New Price} - \text{Old Price}}{\text{Old Price}} \times 100$$

Types of Demand

Based on the PED value, demand can be classified into three main types:

  • Elastic Demand: PED > 1. A significant change in quantity demanded occurs with a small change in price.
  • Inelastic Demand: PED < 1. A small change in quantity demanded occurs with a large change in price.
  • Unit Elastic Demand: PED = 1. The percentage change in quantity demanded is equal to the percentage change in price.

PED and Revenue

The relationship between PED and a firm's revenue is a key aspect of understanding its importance. The impact on revenue depends on whether demand is elastic, inelastic, or unit elastic.

Elastic Demand

When demand is elastic (PED > 1), a decrease in price will lead to a proportionally larger increase in quantity demanded. This means that total revenue will increase. Conversely, an increase in price will lead to a proportionally larger decrease in quantity demanded, resulting in a decrease in total revenue.

Price Quantity Demanded Total Revenue
$10 100 $1000
$9 120 $1080
$8 140 $1120

In this example, as the price decreases, the quantity demanded increases by a larger percentage, leading to an increase in total revenue.

Inelastic Demand

When demand is inelastic (PED < 1), a change in price will lead to a proportionally smaller change in quantity demanded. If the price increases, total revenue will increase. If the price decreases, total revenue will decrease.

Price Quantity Demanded Total Revenue
$10 100 $1000
$11 90 $990
$12 80 $960

Here, even though the quantity demanded decreases, the decrease in price is smaller, resulting in an overall increase in total revenue.

Unit Elastic Demand

When demand is unit elastic (PED = 1), the percentage change in quantity demanded is equal to the percentage change in price. A change in price will result in an equal and opposite change in total revenue. Total revenue remains constant.

Price Quantity Demanded Total Revenue
$10 100 $1000
$11 110 $1210
$10.50 105 $1102.50

In this case, the increase in quantity demanded is directly proportional to the increase in price, keeping total revenue constant.

Factors Affecting PED

Several factors influence the price elasticity of demand:

  • Availability of substitutes: More substitutes lead to more elastic demand.
  • Necessity vs. Luxury: Necessities tend to have inelastic demand. Luxuries tend to have elastic demand.
  • Proportion of income spent: Goods that represent a large proportion of a consumer's income tend to have more elastic demand.
  • Time horizon: Demand tends to be more elastic in the long run than in the short run.

Government Intervention

Governments often consider PED when deciding on taxes. If demand is inelastic, a tax will likely result in increased government revenue. If demand is elastic, a tax may lead to a decrease in government revenue.

Conclusion

Understanding price elasticity of demand is essential for businesses and policymakers. By analyzing PED, firms can make informed pricing decisions to maximize revenue, and governments can design effective taxation policies. The relationship between PED and revenue is a fundamental concept in microeconomics.

Suggested diagram: A graph showing the demand curve and different elasticities of demand (elastic, inelastic, unit elastic) with corresponding revenue curves.